Leveraging the Power of Puts Against Insider Trading

Today we’re diving deeper into using insider trading to filter opportunities in the stock market.

I decided to see what happened when we added insider selling to the screens I use to identify hopelessly overvalued companies experiencing financial difficulty.

I’m by no means a huge trader, but I’m not opposed to putting on a “chicken short” using puts or put spreads from time to time, either.

If you can get a high-probability trade on an overvalued company, then putting a few dollars into a small trade can have huge payouts over time.

But in order to succeed you need the right rules, discipline, and a few good targets like these…

Their Loss Can Be Your Gain

The first screen I use is set up to find companies that have too much debt and are showing signs of severe financial distress.

I don’t mind debt. In fact, companies that have high amounts of leverage, but are generating excess free cash flow that can be used to pay back the debt is one of the best ways to select stocks with the potential for high returns.

Small bets that have the right combinations of probability can be ridiculously profitable if structured correctly – I want to have at least a 4-to-1 payoff potential, and I want to buy as much time as possible.

If structured correctly, and I’m right 25% of the time or more, I will make money.

If I get anything close to 50% right, this strategy will pile up enormous sums of money form a relatively small amount of capital.

I also follow a couple of rules with this approach:

  • I use a small amount of money to bet against distressed companies and other black swan events.
  • If I lose my roll, I’m done until I accumulate more cash.

It’s the same amount I use to wager at the race track or playing poker back when I was single and a day at the track, or an evening at the poker table was still a way to while away the time when the boats weren’t in the water.

Any excess profits are piled back into the core investing strategies that I’ve been sharing with you this past year.

When I limit the trades to just those troubled companies losing money and that also have insider selling in the last month, the result is huge losses for buyers of these stocks and windfall profits for those who bet against them.

Right now, there are just a handful of companies that fit the bill.

Insiders Trading – if you can’t beat em…

A Weak and Vulnerable Market

One of the better targets for this strategy is National Oilwell Varco Inc. (NYSE:NOV).

The oil services company is hostage to oil and gas prices, and they are more of a headwind than a tailwind right now.

The rig count across the U.S. has been falling, and exploration and production activity appears to have leveled out for now.

They’ve been trying to amend and extend their debt and cut costs, but it might not be enough.

If we get a president that is anti-fracking, the company will be in big trouble, quickly.

We can buy options all the way out to 2022, and I would suggest going out as far as possible.

Then I would go down the option chain and buy a put for $1 or less.

A move towards the strike price with increased volatility will make the option price leap higher, and a move to the strike or less would result in enormous gains.

If it doesn’t work, we haven’t even lost enough to cover lunch.

Insecurity in the C-Suite

Not too long-ago FireEye Inc. (NasdaqGS:FEYE) was a market darling and was expected to be one of the big cybersecurity winners.

That scenario hasn’t played out for the company, and the stock has struggled.

The shares are down substantially from the highs of 5 years ago, and insiders are still selling their shares in the company.

Liabilities have been rising quarter after quarter, and the company is losing money right now.

Many observers, this one included, think the only viable option for the company is to find a buyer.

Given the state of the business, that could be a tricky proposition.

Once again, I would go all the way out to the 2022 option chain and buy puts that trade for $1 or less.

We’re betting that the company doesn’t find a buyer or successfully turn around the business.

All we need is a hint of continued losses, and the stock decline and volatility increase can help us meet our target return.

A fall below the strike could yield enormous gains.

How to Win Using Losing Stocks

Using options to bet against companies that are struggling financially works.

A long portfolio of companies that meet these criteria has lost money in the past decade, even as the stock market roared higher.

Making small bets against distressed companies where insiders are actively selling stock is a profitable strategy.

It can be lumpy in nature, but over time, it can put large chunks of cash in your account with a series of reasonably small bets.

If we get the math of probability and payoff right, it’s an excellent addition to our core strategies.

It doesn’t hurt that it can be a fantastic intellectual endeavor that adds to the fun.

To the Max,

Tim Melvin

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