Option premium varies based on the volatility, or risk, of the stock. So it follows that if you pick stocks only based on the richness of option premium, you are favoring high-risk over low-risk stocks. Even conservative traders like those writing covered calls can unintentionally end up with a high-risk portfolio by forgetting this important point.
Stocks should be picked for your portfolio based on their safety and value, and defined within your risk profile. Here are four sensible methods for narrowing down the list:
Revenue and profit growth: No matter what explanations you hear about declining sales and profits, the truth is pretty straightforward: Well managed, competitive companies experience rising sales most years; and net profits should rise as well, with the net return (net operating profit divided by revenues) should at least remain steady, if not also rising over time.
Dividend yield and history: Dividends represent a major share of most investors’ income. So if all else is equal, favor the company paying a better than average dividend. There are plenty of very superior corporations paying more than a 4% dividend. Also look for companies that have increased their dividend per share every year for at least 10 years. These so-called “dividend achievers” tend to be the better-managed companies with carefully managed cash flow and profits.
P/E ratio: Look for companies whose P/E is between 10 and 25. Don’t just use the year-end P/E either, but the average for each fiscal year. Look for steady, consistent reports within this range. Also remember that current P/E might be very inaccurate. It is a comparison between a technical indicator (price) and a fundamental one (earnings). The timing is also off, because price is today’s number but earnings is from the last quarter.
Debt ratio trend: The current ratio is a favorite fast test of work capital, but it can also be inaccurate. The current ratio by itself does not reveal how long-term debt is being managed. In fact, as company losing money every year can maintain the current ratio at 1 or better even with losses, if it just lets long-term debt levels rise. The higher the long-term debt, the less future profits will be available for dividends and expansion; and the more has to go to debt service and interest. Divide long-term debt by total capitalization (combined long-term debt and shareholders’ equity) to get the percentage. Check the last five years or more to find the trend. If the debt ratio is rising, watch out.
Start out using these basic tests for high-quality stocks. Then, once you qualify the company, use those stocks as cover for your short calls, or for other option trades.
Michael C. Thomsett is an investing and options author and has also written for FT Press’ Agile Investor series, which can be viewed on FTPress.com. Thomsett’s latest FT Press book is Trading with Candlesticks. He also contributes to the CBOE newly-formed blog.