Michael Thomsett, of ThomsettOptions.com, explains that a common option trading error is picking stocks based solely on premium of the call, since the more volatile the stock, the more implied volatility in the option. He also offers four basic guidelines for conservative traders to consider instead.
You can make impressive double-digit returns with covered calls (on an annualized basis). In fact, the shorter-term expirations yield more, so you’re better off writing several shorter-term, smaller premium calls per year than one or two big-dollar but lower-return strikes.
A common error is picking stocks based only on premium of the call. The more volatile the stock, the more implied volatility in the option; therein lies the problem. If you pick stocks just to write covered calls, you may be taking on more risk than you actually want.
If you are conservative, use four basic guidelines for picking solid, safer stocks for covered call writing:
- Revenues and net profit should be rising every year. When you see erratic operating results, net losses, or falling profits, you should be troubled. Look for stocks to buy in profitable and competitive corporations.
- The debt ratio should be small and either falling or staying steady. Avoid companies whose debt ratio is higher than the average of its competitors, especially if that ratio keeps rising every year. Total capitalization (long-term debt plus equity) should include a sensible mix between equity and long-term debt, but when the debt side starts climbing, it gets more and more difficult to get out of the hole.
- The P/E should be moderate. As a general rule, look for a P/E ratio between 10 and 25. Any P/E under 10 indicates lack of interest in the company; any P/E above 25 starts to mean the stock is expensive. Also, don’t just look at today’s P/E. Compare high/low P/E levels over several years, looking for consistency in the range.
- Pay attention to dividend yield. If all else is equal, select the company with the higher dividend. The yield is the dividend per share divided by current price per share, so the yield you earn is based on the price when you buy. Also seek companies whose dividend has been increased every year for at least ten years. These so-called dividend achievers tend to be the best-managed companies. Finally, also check the dividend payout ratio (percentage of earnings paid in dividends) and make sure it is not falling as dividend per share increases each year.
Covered calls contain risks like all strategies. Perhaps the greatest risk is assuming a sure thing but picking the wrong stock. Always buy stock on sound fundamentals like those listed above and never just to trade options.
By Michael Thomsett of ThomsettOptions.com
