TRADING ADDICTS. Lesson 2: Stock and Option Selection. Selecting a Stock. Copyright 2010, Trading Addicts, LLC. All Rights Reserved

Transcription

1 Lesson 2: Stock and Option Selection In this chapter, we will be focusing on the process of selecting a stock. The most important part of any Covered Call strategy will be the underlying stock you choose to buy. Since you will need to purchase shares of stock, you ll want to make sure that the capital you invest will be going towards a suitable investment. Therefore, the qualities you look for in the stock you purchase are an important prerequisite to a successful trading approach. Here are a few specifics we ll be discussing in this chapter: Selecting a Stock You Want to Own Selecting a Stock for the Covered Call Strategy Selecting a Stock Based on Listed Options Enhancing Returns With High Yield Stocks Selecting a Stock There are a few different ways to approach Covered Call trading, when it comes to the purchase of stock. For example, you might prefer to find several good quality stocks to invest in for the long term, and use them on a monthly basis to generate income through the use of Covered Calls. Another example would be someone who might not care too much about owning stocks for the long term, but would rather select stocks for Covered Calls based on returns they could get from stocks that generally have more expensive option premiums. You might also find that the selection of a stock comes down to not just good fundamentals, technicals, or other stock qualities, but rather based on the quality of the underlying options. Let s start with the qualities of a stock you d want to own. If you ve purchased stock in the past, then you won t need to gravitate too far away from what you already know. After all, if you re buying stock, find a good company that is going to appreciate in value. This should be the ultimate goal, regardless of whether or not you decide to trade Covered Calls. Note: A common misconception to selecting stocks for a Covered Call strategy is to purchase stocks that stay in a narrow range, and do not increase or decrease much in value. This is false! Remember, the capital invested in the equity is much more than what you ll receive in monthly premiums. Put that capital to work in a good performing stock. You ll just want to be particular in the timing of when to sell calls.

2 From a fundamental perspective, continue to look for strong fundamental conditions, like you would any other long term investment. Look for companies in good industry groups, that provide products or services that are in demand, regardless of economic conditions. Earnings growth over a multi-year time frame, as well as accelerated earnings in most recent quarters is always a positive sign. A return on equity of 18% or more is another strong quality of preference. Focus on stocks with low debt/equity ratios, and that are preferably cash rich. Finally, look for insider transactions that are reflective of management that is bullish on the direction of the company and the stock price. From a technical perspective, focus on long term trends. Aside from tumultuous market conditions, look for a steady price trend that has stood the test of time, and one that is worth investing in for the time to come. Also, it is imperative to make sure that your stock is a leader in its industry through a relative strength analysis. As an example, let s assume we are looking to buy shares in a Gold Mining company. We ve narrowed our decision down to Newmont Mining Corp, Goldcorp, and Kinross Gold Co. Assuming we ve settled on the fundamental conditions, technical analysis, and all other forms of analysis, let s see how the performance of the stocks rank against the benchmark of performance for the industry group, which is the Market Vectors Gold Miner ETF, ticker symbol GDX. In this example, we ll use stockcharts.com. Simply type in the symbol of the company you are interested in, followed by a colon, and then the symbol you wish to compare performance against. In this example, we will look at the relative strength of Newmont Mining Corp, Goldcorp, and Kinross Gold Co versus the Market Vectors Gold Miner ETF ( NEM:GDX, GG:GDX, and KGC:GDX). Here are the relative strength comparisons for each stock. The graphs above show now each stock has performed against a common denominator, which is the GDX. As you can see, Newmont has outperformed the GDX, while Goldcorp has slightly underperformed, and Kinross has significantly underperformed. This will help to give you a visual interpretation of which company is a leader against its peers.

3 A few final considerations to take into account would be trading volume and stock volatility. When looking for a candidate to trade Covered Calls, make sure the underlying stock is liquid enough to trade, and that volume levels are continually growing over the years. In terms of volatility, it is a personal preference. Stocks with a low beta or volatility rank will not typically produce wild price swings, and generally speaking are easier to manage within a portfolio and within a Covered Call trading system. Stocks that are more volatile might produce better option premiums, but will also generate price swings that can increase the probability of a loss over the life of the trade. Next, we ll discuss selecting a stock based on the availability and characteristics of the underlying options. Listed Options If you are selecting a stock based on options, the most important element for your consideration is liquidity. Therefore, avoid illiquid options and focus on equity options that have adequate open interest, volume, and narrow bid/ask spreads. Note: Some equity options trade in penny wide spreads. This is a big advantage to the retail trader as it helps to reduce costs and enhance returns. Not all equity options are penny priced, but those that offer penny wide spreads are more advantageous to trade. It is not mandatory to trade them, but the more liquid the options are, the better they are to trade. One method that is commonly used to select Covered Call candidates is to locate expensive option premiums, and sell them against a long stock position. Implied volatility is what will ultimately determine whether an option premium is cheap or expensive. Many traders will scan for options with high implied volatility levels, relative to historical volatility levels. The thought process is to sell these options while they are expensive, looking for volatility to revert back to its mean. However, high implied volatility reflects a high demand for options, or an increase in the expected return of these options. As an example, implied volatility will usually increase around events, such as earnings, product releases, or any other event that will cause the stock to move. Essentially, the increase in implied volatility reflects the market pricing in the expected return, which creates more expensive options. Let s look at a quick example. Below are a few theoretical calculations based on a $50 stock, and the underlying options at a $50 strike price. Assuming 45 days until expiration, and an implied volatility level of 25%, the theoretical value of the call would be $1.80, and the theoretical value of the put at $1.78.

4 Let s review the exact same example, but increase implied volatility. The relative range of an options implied volatility will fluctuate a good amount, some times more than others, depending on what expectations are for the stock. Here s another look at the same example; this time with implied volatility at 50%. Again, theoretically, this is the same stock, the same strike, as well as the same time until expiration. The only factor that has changed is an increase in implied volatility. This has more than doubled the price of the options. It is important to understand this concept so that you ll understand when options are cheap or expensive. However, you must take caution with options that are trading at high volatility levels. This means that the market is expecting price to fluctuate dramatically, which might not be conducive to owning stock, especially if the stock price is to move substantially lower over the life of the option. Stocks that are generally more volatile will simply trade at higher premiums. It is absolutely acceptable to trade Covered Calls on stocks that are more volatile. In fact, it is not uncommon to generate 5-8% returns per month on a buy-write strategy that focuses on more volatile stocks. However, volatility should be interpreted as risk, and the longer you own a volatile stock, the greater the risk involved. One other consideration you ll want to review is the availability of the underlying options. As an example, our Covered Call trading approach will rely on the availability of Weekly options in many of the candidates we trade. Therefore, for a select number of positions, this will be a mandatory pre-requisite.

5 Enhancing Returns With High Yield Stocks On final consideration in the process of selecting a stock should be based on yield. High yield stocks will be in high demand for years to come, meaning they ought to perform well against the broad market. Aside from stock performance, dividend paying stocks will not only provide good returns on the capital invested, but you ll be adding dividend payments on top of the income you receive by selling monthly and weekly call options. If you are an individual looking for a group of stocks to invest in over longer term time horizons, it is important to look for stocks with a high dividend yield. Note: Just because a company pays a high dividend yield, does not mean that it is a suitable investment vehicle. Make sure to conduct a thorough analysis of the company s financial condition before your purchase. It is also important to note that a company s past dividend yield or payment structure will be the same in the future. If the company is struggling financially, it is possible that dividend yield and or payments will be affected by this. In closing, the process for selecting a stock is an important step in the Covered Call strategy. Make sure to spend adequate time covering all your bases in this step, to insure you ve got a quality company to invest in over your time horizon, and one that will be able to produce worthwhile returns through a Covered Call trading system.