by Dan Keen
Price Range – Stocks above $20 are generally not going to give us the best return on our investment, since we have to invest much more money and premium prices will not necessarily be any higher. For example, buying 100 shares of a stock that costs $10 a share then writing a covered call paying a premium of $1 per share, would give you a 10% return on investment (100 shares cost $1,000: 100 shares pays $100 premium).
(Profit / Cost) x 100 = % Return
($100 / $1,000) x 100 = 10%
But an expensive stock will not necessarily pay any higher premium. Buying 100 shares of a high priced stock, say $50 a share, which also pays a premium of $1 per share, would only yield 2% return.
(Profit / Cost) x 100 = % Return
($100 / $5,000) x 100 = 2%
Why risk the extra money to make the same dollar amount profit and a lower return on investment? Unless, it’s a stock that you want to hold long term, such as Coca Cola or IBM, it doesn’t make sense to write covered calls on high priced stocks. Of course, the option writer must always be prepared to give up the stock if called out.
Another reason to play less expensive stocks is so that you have more money available to buy other stocks, and have multiple plays going on simultaneously. The more covered calls in play, the more income coming in. Also, diversifying your speculative capital into different stocks reduces risk, should a sector become out-of-favor with investors.
Step #1 – Price Range: Stocks that are between $5 and $20
Step #2 – Strike Price Proximity: Stocks whose prices are close to the next higher strike price
Step #3 – Optionable: Stocks that are optionable
Step #4 – Fundamentals: Stocks whose fundamentals are favorable
Step #5 – Technicals: Stocks whose charts are favorable
Step #6 – The Sector & The Market: Stocks whose sectors are doing well, or that at least are not out-of-favor with “the crowd”
Step #7 – Return on Investment: Stocks whose premiums pay a good return on investment
This is your list of possibilities.
Strike Price Proximity – For our “hit and run” covered call plays, where we are not interested in holding the stock long term, and are simply looking for generating quick cash, scan for stocks whose prices are just below the next higher strike price (slightly “out-of-the-money”). Strike prices are $5, $7.50, $10, $12.50, $15, $17.50 and $20.00. Let’s avoid stocks with prices under $5, as these stocks may be risky and more vulnerable to price changes. So then, we are looking for stocks that are priced about $7 to $7.49, $9.50 to $9.99, $12.00 to $12.49, and so on. Option premiums will be highest as the price approaches a strike price.
Optionable – Obviously, the stock must be optionable. Investor’s Business Daily newspaper conveniently includes an “o” symbol next to stocks listed in their stock tables that are optionable. You can also use the Internet and look up stocks on sites that give option chain listings, such as www.cboe.com. Enter the stock ticker symbol, and if its optionable you will get a listing of the option prices, otherwise a “symbol not found” or similar message will be returned.
Fundamental Analysis – Our list now consists of stocks that meet our initial criteria: being in our price range, are optional, and are just slightly out-of-the-money, which should give them the best chance of having a high premium. But our list is still too big, and we really haven’t learned anything about these companies. We must continue to refine the list by checking some key fundamental and technical characteristics, evaluating the sector and the market, and then finally by determining if the play would be significantly profitable.
Fundamental analysis is a means of evaluating a company based on economic data, focusing on the company’s earnings and growth potential. Fundamental analysis is useful for evaluating a stock investment for the long term. But determining that a company is well-positioned for future growth won’t help us too much in the short time frame of writing covered calls, unless it is a company you wouldn’t mind owning long term. Nevertheless, there are some fundamental parameters that we should look at, including average daily shares traded, earnings, beta (a measure of volatility), and news on earnings announcements.
Ask yourself questions about the stock you are evaluating. Are the company’s earnings better this year than last? Do they have good management in place? Do they have good products or services that fill a need? How do they compare to their competitors?
Volume – To reduce risk, the stocks we pick should have a healthy number of shares traded daily. Good liquidity ensures it will be easy to buy and sell the stock when we want to. Also, stocks with low daily volumes may have their price greatly influenced by small amounts of buying and selling activity. Set a minimum limit of 50,000 or 100,000 shares traded daily as your requirement for a stock to make your list.
P/E Ratio – Price to earnings ratio, or P/E, is a measure of the value the market places on a company’s shares relative to the earnings being generated by that company’s operation. P/E gives you an idea of how much other investors are willing to pay for a company’s earning power. The higher the P/E, the more “the crowd” is willing to pay, and therefore the more earnings growth they are expecting. If the P/E ratio of a company is 15, you would expect the company to be growing at about 15% a year.
P/E can also be thought of as a number of years it will take a company to earn back the amount of your initial investment (assuming the earnings remain fairly constant, which of course, they may not). A P/E of 10 would then indicate about 10 years.
It is difficult to determine if a company’s P/E is a good deal or a risky one. Small companies are expected to grow at a faster rate than big companies, so they may have a higher P/E ratio. Certain industries will typically have high or low P/Es. It is not unusual for technology stocks and stocks listed on the NASDAQ stock exchange to have higher P/Es than those on the New York Stock Exchange. You can expect higher P/Es in a bull market, and lower ones in a bear market.
As a rule of thumb, it is difficult for any company to maintain a growth rate above 25% a year, so be cautious when evaluating companies with a high P/E ratio. The higher the P/E, the more optimistic investors are about the company’s future earnings. If a stock has a high P/E, be sure it has a strong growth rate to support it.
Beta – Beta is a measurement of the volatility of a stock compared to the stock market as a whole. The S&P 500 is often used to represent the market as a whole. A beta of 1.0 means the volatility of the stock is the same as the market. A stock with a beta of 1.0 can be expected to go up and down along with the market.
To further narrow down the list you may want to check the beta of your potential covered call stocks. Some covered call writers like to consider a stock’s beta value, which is one of the fundamental statistics of a stock. When writing covered calls, look for a stock that has a little volatility, whose beta is between 1.0 and 1.5. A little bit of volatility will make the premiums higher, and thus pay more when writing a covered call.
Beta is used by the market makers as one of the factors in determining the value of an option. A higher beta will give an option a higher premium. However, it also means there is more risk involved. There is an increased chance the stock will move up or down in a wider price range. A stock with a value of 1.0 to 1.5 should have a decent option premium, yet only carry moderate risk. Short-term news may cause a stock’s beta to dip below 1.0 or jump above 1.5, but that stock may not make for a good long-term investment.
Some internet sites list the beta factor along with other fundamentals such as P/E ratios, dividends and average daily volume.
The Web site NASDAQ also has a free stock screening section.
Simple Technical Analysis – Technical analysis is also referred to as “chart analysis”, a means of evaluating a company by studying its price activity using historical stock charts, and looking for patterns as clues to possible future price movement. It has been said that fundamental analysis is concerned with the “why” of the market behavior, and technical analysis deals with the “when”. Technical analysis is considered to be a combination of art and science, because of the subjective interpretation of data. Sometimes different technical indicators will give conflicting forecasts. Technical analysis also assumes that once a pattern is detected, the price will continue to move in that pattern, which is not always the case.
Nevertheless, charts are very useful tools. A price chart gives a clear visual picture of recent, as well as historical, price movements. It can define trading ranges to help determined when to buy or sell a stock.