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Options Trading: Picking the Right Stocks

By  Jan 14, 2010

Topics: Finance & Investing

The more volatile the stock, the richer the option premium. However, your criteria for picking stocks should never be based on premium levels, but on sound, reasonable methods. I like five criteria in particular for picking stocks.

There are an unlimited number of methods for picking stocks for option trading. I challenge the idea, though, that stocks should be picked for options. Instead, stocks should be picked based on their value and your risk profile. Here are five sensible methods for narrowing down the list:

Profitability and growth: Stock values tend to rise over time when revenues and net profits also rise. With this in mind, it makes sense to narrow down your list to those stocks experiencing growth over a full decade. This growth should be seen in both revenues and net profits.

 Core earnings stability: The concept of “core earnings” was first introduced by S&P a few years ago. It is the earnings a company books from its primary activity. Excluded are capital gains, currency exchange gains or losses, accounting adjustments, and the sale of segments or subsidiaries. You will notice that companies with little or nothing in the way of core earnings adjustments tend to trade with less volatility and to grow over time.

Dividend yield and consistency: Don’t overlook the long-term importance of dividend yield in the overall profitability picture. In addition to capital gains and option-based income, dividend yield represents a major factor in the big picture. You will gain even more than the yield at the time of purchase, if you reinvest dividends. That makes the yield a compound yield. For example, you might decide to invest only on companies yielding 3% or more -- that shortens everyone’s list to a few select companies.

 P/E ratio: The multiple assumes what the market believes in terms of future price appreciation. The other side of this perception coin is that the higher the P/E, the more a stock tends to be over-priced. On the other extreme, extremely low-P/E stocks do not command enough market interest to generate growth -- or so the argument goes. Setting a range makes sense. For example, you might limit your stock candidates to those with P/E between 10 and 25. This is a typical and reasonable mid-range P/E level.

Debt ratio trend: Finally, don’t overlook the debt ratio. This is the percentage that long-term debt represents of total capitalization (combined long-term debt and shareholders’ equity). When you see the percentage climbing over the years, it’s a danger signal. For an example, look back at GM’s history. Once the debt ratio went over 100%, there was really no chance of recovery. You should see the debt ratio steady or even falling. The best-managed companies report little volatility and no growth in the debt ratio.

This indicator is more reliable than the more traditional test of working capital, the current ratio. A company may commit itself to long-term debt and hold the proceeds in cash to maintain that current ratio of 2 … but this is done at the growth of future interest expense, meaning less capital left over to fund growth or to pay dividends.

Pick stocks with these criteria in mind, not option premium levels. The short list of stocks meeting your combined criteria will turn out to be the best-managed, most competitive companies -- and quite possibly also the best candidates for strategies like covered call writing.