Four weeks ago, I told you about a trading strategy specifically designed to reduce exposure to market volatility, preserve capital and generate income. I know it sounded almost too good to be true, but those readers who acted on the specific trade in that issue are on their way to scoring a quick 12% return.

The specific recommendation in this instance involved independent oil refiner Phillips 66 (NYSE: PSX) and came courtesy of my colleague Amber Hestla-Barnhart, an options strategist at ProfitableTrading.com, a StreetAuthority sister site.

Based on the company’s solid fundamentals, Amber determined Phillips was a company she was “more than comfortable” owning at what was then a price of $50.60 a share. But by selling puts, Amber could collect instant income upfront without having to purchase shares outright. If shares fell, she would be a shareholder at “dirt cheap” prices.

In options lingo, Amber at the time was looking at Feb $48 puts at $1.15. That’s a put that expires in February (after the third Friday of the month, as is the case with all stock options). This “put” paid Amber, the seller or options “writer,” a premium of $1.15 per share, or $115 per contract, which was hers to keep, no matter what. (Most brokers require a small margin requirement or “down payment” to sell puts. In this trade, the down payment amounted to about $960.)#-ad_banner-#

If Phillips 66 were to trade under $48 a share during the life of the contract, Amber would become a stockholder at a cost basis of $46.85 per share ($48 – $1.15, her premium). The down payment at the brokerage would go toward purchasing the shares — at a discount to the price Amber was originally “comfortable” with, at a price she knew up front, before the trade was made.

If shares go on to stay above $48 through this week’s expiration, as almost certainly will be the case in this instance, the options will expire worthless to the buyers, and Amber won’t have to purchase a single share. She’ll get her deposit back, and the $115 per contract — the “instant income” — is pure profit.

“Selling puts is one of the smartest, highest-percentage trades you can make in the market.”

And lest you think Amber’s Phillips 66 trade was a fluke, read on…

In much the same way that I — and you, as StreetAuthority readers — followed Amber’s strategy with Phillips 66 in real time, so have the honchos at Profitable Trading gotten to know her style.

Since last summer, Amber agreed to test the results of her options strategy with the staff at StreetAuthority’s sister company looking over her shoulder. As with Phillips 66, Amber looked to sell put options primarily on dominant, blue-chip companies.

Amber passed her beta test with flying colors. Between July 31, 2012, and Jan. 28, 2013, she executed 13 trades, 11 of which were winners. That’s a success rate of 84.6%.

“Selling puts is one of the smartest, highest-percentage trades you can make in the market,” Amber contends. “You’re betting that a great company won’t fall to fire-sale prices in a short period of time.”

Among the “great companies” involved in Amber’s put strategy in the past six months: MasterCard (NYSE: MA), which returned 42.2% more than 172 days on a “down payment” of $6,400; Amazon (NYSE: AMZN), which delivered $750 from a down payment of $4,400, and Coach (NYSE: COH), which returned 14.2% in 109 days on a down payment of only $880.

Another key to the success of this former military analyst: her unique ability to spot patterns that others miss and an often-overlooked “glitch” in the options markets.

Here’s more…

Bob: What is the “glitch” in the options market, and how are you taking advantage of it?

Amber: Most options traders lose money for one simple reason — they’re on the wrong side of the trade. You see, more than 80% of options expire worthless.

That may sound like a bad thing, but my strategy involves selling, not buying options. When I sell an option, money is deposited in my brokerage account. It’s called a premium, as you’ve already noted, and I like to refer to it as “instant income.” In other words, I get paid upfront for options that more than likely will expire worthless in a few months, allowing me to keep 100% of my instant income.

While most options expire worthless for the buyer, the premium collected upfront by the seller is certainly not worthless. It’s this “glitch” in the options market that makes it possible to generate steady income selling options.

That’s the general idea behind my strategy, but let me go into a little more detail so readers understand there is a logical reason why the overwhelming majority of options expire worthless.

One reason is that many investors make unwise financial bets. They treat options like lottery tickets and lose money more often than not.

Options are also designed to decrease in value. In more technical terms, options are a wasting asset, which means they decline in value every day you own them. They are like new cars that depreciate when you drive them off the lot and lose a little more in value every day after that. The money is lost by the buyer, not the seller. Knowing this, to make consistent money trading options, we should be sellers.

All options have an expiration date, which gives buyers a limited amount of time to exercise their right to buy (call option) or sell (put option) the stock or exchange-traded fund (ETF) the option is for. If an option can be profitably exercised, it is said to be “in the money,” and options that cannot be profitably exercised are called “out of the money.” With each passing day, the chance that an out-of-the-money option will be exercised decreases, and that makes the option just a little bit less valuable to the holder.

On their expiration day, most options will be worthless, so options buyers are tasked with the difficult job of picking the right option, something they accomplish less than 20% of the time. Sellers of those options, on the other hand, will show profits the majority of the time. In my advisory, Income Trader, I take advantage of this situation by being the seller.

Bob: What kind of recommendations are you making in Income Trader?

Amber: My primary objective is to protect capital, and my secondary objective is to generate income from that capital by selling options. All of my recommendations follow those principles — safety and income. For the most part, I recommend selling options on high-quality, undervalued stocks.

When selling put options, there is a chance I will become a shareholder, so one of the most important parts of my strategy is choosing the right stocks. That means stocks that have the potential to be long-term winners that I want to own.

I focus on stocks with low PEG (price/earnings to growth) ratios, for example. The PEG ratio is a derivative of the price-to-earnings (P/E) ratio that takes into account future growth in earnings. To find the PEG ratio, I divide the P/E ratio by the earnings growth rate. This ratio finds promising value stocks without ignoring growth stocks. Companies that are growing earnings faster than average deserve a higher-than-average P/E ratio, and the PEG ratio accounts for that. There are other value metrics I analyze, but the PEG ratio is where I often start my search for great stocks.

After finding undervalued stocks, I use puts to develop strategies that allow me to collect income and occasionally buy them at a discount of 5%-10% or more below fair value. In most cases, I won’t have to buy shares, and I book the premium as pure profit. If I am obligated to buy the shares, then I’ll own a great company at a dirt-cheap price.

As for the time frame, the options I sell generally expire in one to two months, which makes the investments liquid, meaning my money is not tied up for long periods of time. Depending on the market, I might sell longer-term options, but most of my income plays in Income Trader are short term.

Bob: Selling puts appears to work well in flat to up markets. Do you shift strategies when the market is trending down?

Amber: My basic strategy remains unchanged even in a falling market, but there are some different tactics I use.

Option prices adapt to the market environment, and the premiums on most options should be higher if the market is falling. This is due to the fact that volatility, an important factor in options pricing, should rise in falling markets. And when volatility rises, so do premiums.

For example, I generally sell puts with strike prices that are below the current price of the stock. During bull markets or times when prices are trendless, the strike prices on the options will usually be close to the market price. In a down-trending market, I might leave more room between the market price and the option’s strike price. Since I’ll generate more income from high-priced options, the optimal risk-reward ratio will be found in options with lower strikes.

My primary objective is to safely deliver income, and that will require adapting as the market changes. The strategy will remain consistent, but how it’s executed it will be determined by the market. Options selling works in any environment, but the best options to use will always be determined by the math.

Bob: You’ve mentioned that the VIX is an important factor in options prices, can you elaborate?

Amber: The CBOE Volatility Index (VIX) is one of the most important indicators to follow when selling options.

Option prices are determined by several factors, including the underlying stock’s price, the exercise price of the option, and the amount of time until the options contract expires. These can all be easily determined, but one factor that is more difficult to assess is volatility.

Volatility refers to how much a stock’s price moves. A stock that gains or loses an average of 2% a week is considered to be more volatile than one that moves only 0.5% a week on average.

I can get a general idea of whether volatility is high or low by looking at the VIX. The VIX is commonly called the “fear index,” because it tends to rise as the market falls and traders become more anxious. On the other hand, when market prices rise, the VIX tends to decline.

The chart below shows that the VIX itself is a volatile indicator.

Here’s why it matters: Options prices, in general, move in the same direction as the VIX. That means options are expensive when the VIX is high and cheap when the VIX is low.

And I think options sellers are about to get a huge opportunity to sell high-priced options. As you can see in the chart above, the VIX tends to spike higher when it hits the 15 to 13 range. When that happens, I’ll be ready to collect large chunks of income from my favorite stocks.

But even if the VIX stays flat for a while, there are always a few great income-generating opportunities in the market.

Bob: Can you give me an example of a “great income-generating opportunity” you’ve found recently?

Amber: Sure. In this week’s issue of Income Trader, I took advantage of “the worst analyst call of the month” to collect income. As I mentioned above, volatility in a company’s shares causes options prices to move higher. And after the news broke that PetSmart (Nasdaq: PETM) had been lowered to a “Reduce” rating from “Neutral,” the stock sold off more than 10% in one day.

According to the analyst, Amazon.com (Nasdaq: AMZN) could become a competitor to PetSmart as shipping costs fall. I don’t agree with that call. For one thing, UPS (NYSE: UPS), FedEx (NYSE: FDX) and the U.S. Postal Service all raised shipping rates recently.

It’s also not the first time PetSmart has been “threatened” by an online retailer. Pets.com, the former online pet supplies retailer, is best known for its high-profile advertising campaign featuring a dog sock puppet and going out of business in November 2000, within a year of going public. PetSmart now owns the Pets.com domain.

In fact, nothing has stopped PetSmart from growing revenue year after year. The company has increased revenue every year since its IPO in 1992, a period that includes two recessions.

Needless to say, I believe that PETM is a great long-term investment. But by selling puts, I could collect instant income without having to purchase shares outright. And if I did get the chance to buy shares, it would be at a significant discount to market price at the time.

I advised readers to sell PETM March 60 Puts for around 80 cents a share to take advantage of the fall in price and increase in volatility. That’s a put that expires in March that pays sellers an 80 cents a share premium, or $80 per contract. If shares of PETM trade below $60 a share, we’ll be shareholders at a cost basis of $59.20 a share ($60 – $0.80, our premium). When I sold the put, shares were trading at $65.40, so our cost basis would represent a 9.5% discount.

Assuming PETM trades for $60 or more until March 15 (when the option expires), we keep the premium and make a profit of $80 on a $1,200 down payment, or 6.7%, in 37 days. If we can repeat a similar trade every 37 days, we’d earn a 66% return on our capital in 12 months.

Worst case: If PETM trades for less than $60 before March 15, then we’ll keep the $80, but we’ll have to buy PETM stock at $60 per share. In this case, we’d own PETM at a cost basis of $59.20 (the $60 strike minus the $0.80 premium, which we keep). At $59.20, we’d own shares at 15 times 2014 estimated earnings — a bargain for a stock expected to grow earnings at about 18% a year in the short term.

Action to Take –> These are the kinds of trades I look for in my weekly Income Trader newsletter. My goal is to create “no-lose” situations. Of course, there’s no such thing in the financial world, but I think selling puts on stocks you want to own is as close as it gets. It’s like getting paid to set limit-orders on your favorite stocks.

P.S. — To hear a presentation from Amber about Income Trader and to learn more about Amber’s income strategy, click here.