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12/09/2010

Picking the Right Stock and the Right Strike


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Picking the best stock for writing covered calls requires the same analysis as you use for picking stocks without options in mind. There are many criteria for this: fundamental, technical, or a combination of both. Some people want to hold stock for many months or years, while others want to earn a profit quickly and trade in and out of positions quickly. Your stock selection depends on your risk profile and your investment attitude and philosophy. Stocks should not be picked solely as good option-writing candidates, although that may serve as one of several criteria you employ.

The “right” stock is going to meet the risk and market standards you set for yourself. A conservative investor is likely to prefer “value stocks”—well-managed companies with a well-established track record and exceptional management currently selling at a bargain price. Speculators or technicians tend to trade shorter-term and base their decisions on chart patterns and signals. Most traders should not pick a stock and buy shares only to sell covered calls. This would result in buying the highest-risk stocks rather than those best suited to your risk tolerance.

Among the favorite methods for stock picking are the following:

  1. Levels of volatility and market risk. The more volatile the stock, the greater the opportunity for price appreciation or decline. More volatile stocks also tend to provide richer option opportunities and a corresponding higher risk.
  2. Price/earnings ratio levels. Opinions vary, but most agree that a P/E ratio between 10 and 20 is “reasonable” in terms of the stock’s current price level. Exceptionally high P/E stocks are popular but overpriced. And very low P/E stocks tend to move slowly and within a narrow trading range, making them less attractive for options trading.
  3. Dividend yield. This is a major segment of overall return although the yield often is ignored or forgotten. An especially effective way to pick stocks is by isolating the selection to “dividend achievers,” those companies whose dividend has been increased every year for at least 10 years.
  4. Quality of management and sector competitive position. Favored stocks are often those with many decades of history, strongly capitalized, and that dominate their sector. Exceptional management also is a sound method for picking companies.
  5. Growth in revenues and net profits. The fundamental test of “success” is increasing revenues and profits. Companies exhibiting growth every year tend to also make excellent option candidates.

–Michael C. Thomsett. Excerpted from Practical Considerations in Picking the Covered Call by Michael C. Thomsett (FT Press Delivers Insights for the Agile Investor).

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