CHAPTER 1

Setting the Ground Rules

This book explains how conservative investors can employ options strategies to (a) enhance current income without increasing market risks; (b) protect long positions through options used for insurance; and (c) create a form of contingency to survive in volatile market conditions.

The Ground Rules

Since you are a conservative investor, the arguments in this book are based on a series of underlying assumptions. These relate to your risk profile and to your investing philosophy. Five underlying assumptions are used in this book:

1. You will limit options activities to prequalified stocks. This is a necessary starting point if your portfolio and the stocks you use for options strategies include stocks you believe in as long-term-hold positions, and you consider these stocks as permanent parts of your portfolio (if the fundamentals remain strong). This is an important attribute because it is not conservative to buy stocks solely to use for options strategies. A conservative approach to options must include the premise that your activities will be limited to the strongest possible stocks you can find.
2. You believe that your stocks will rise in value. A conservative investor naturally expects stocks to rise in value; otherwise, why keep them? But this obvious point has relevance in the underlying assumptions of this book. Many of the discussions of strategies are premised on a belief that over the long term, the subject stock’s market value will rise. However, many options strategies work best when stocks do not rise, such as bearish combinations or long put strategies. Covered call writing (a conservative strategy) is most profitable when stock values remain steady or even fall slightly. This means that you may need to time a strategy to produce profits resulting from short-term stability in prices, hoping for longer-term growth. Many options strategies are designed to take advantage of short-term price volatility. When marketwide volatility affects short-term prices of your stocks, you have an opportunity to pick up discounted shares, take profits (without having to sell stock), or average down your overall basis. Of course, the proposal that you should average down is conservative only if the basic stock selection assumptions remain valid. You will want to employ such a strategy only for stocks in which you have a strong belief as long-term value investments.
3. You accept the premise that fundamental analysis of stocks is an essential first step in the process of examining option opportunities. Options have no fundamental attributes. These are intangible contractual instruments, and they have no value on their own; thus, you can only judge the tangible value of stock as a means for selecting appropriate options strategies. Many first-time options traders make the mistake of overlooking this reality. They select options (and stocks) based on the immediate return potential, but they ignore the market risks of the underlying stocks. This violates the conservative tenet that stocks should be chosen for their fundamental strength and growth potential.
4. In the event of a temporary downward movement in a stock’s price, you would be happy to buy more shares. Some investors may be unwilling to pick up more shares of a stock even when the opportunity to buy discounted shares is presented. In this book, several strategies are introduced proposing that additional shares may be purchased (or exposed to contingent purchase) using options. If this is not the case in a situation, those suggestions should be passed over. You may have a formula for diversification that you use to limit risks in any stocks, for example, so strategies aimed at increasing your holdings in one stock may contradict your portfolio management standards in such an instance. Strategies proposing that you set up situations in which more shares may be picked up work only if that suggestion conforms to your overall portfolio plan.
5. You believe that an adequate number of available stocks meet your criteria. Some investors become convinced that their short list of stocks is the only list available to them. If they were to sell shares of stock from their portfolio, they would be unable to reinvest profits in equally acceptable stocks. If you do not believe this, you are probably aware that dozens of stocks meet your criteria in terms of price level, price/earnings (PE) ratio, volatility, dividend payment history, and a range of other analytical tests. Accordingly, if a stock is sold from your portfolio, several other stocks that you could and would purchase upon sale of stocks you currently own also conform to your criteria.

This set of rules makes sense whether you trade options or not. The fundamentals can change for any company, so if a “hold” signal changes to “sell,” you need to reinvest funds. As a matter of basic portfolio management, every investor needs a secondary list of stocks that would be used to replace sold stocks from the current portfolio. The need for maintaining this list relates to options trading because some strategies result in selling shares of stock. In those cases, you want to reinvest capital in a new issue on your list of qualified stocks.

A Model Portfolio

In the examples used in the following chapters, these five underlying assumptions demonstrate how options work within the conservative framework. These criteria are applied to a model portfolio of three stocks, which are used in various combinations throughout. This helps to tie together the various examples and range of possible outcomes. This model portfolio is by no means a recommendation of stocks you should own. It was selected to include stocks with some common attributes:

• They have increased dividends every year for the past 7 and 10 years (or more) and have reported low volatility in trading.
• Dividend yields are higher than average, between 4.75 and 6.63 percent.
• All these stocks have available both listed options and long-term options (Long-term Equity AnticiPation Security [LEAPS]), enabling you to look at a variety of scenarios for each conservative strategy. Analysis includes a study of options expiring in 1 week, and in 1, 2, 4, and 16 months.
• All reported 10-year PE ranges falling within a moderate range.
• Both revenue and earnings rose during the 10-year period studied.
• Debt to capitalization ratio remained steady or declined over the decade.

Employing a single portfolio throughout the book is helpful in another way. Not every strategy works well for each stock in the model portfolio, so you can walk through the selection process to demonstrate how a strategic decision is made. Although your portfolio may contain several excellent value investments, some strategies simply do not always work in all cases. You can compare the different potentials for strategies across a range of stocks by following the model portfolio throughout the explanations in each chapter.

Table 1.1 summarizes this model portfolio, consisting of AT&T, Southern Co., and Altria and based on valuation at the closings prices of April 25, 2019. These represent three industries: telecommunications, energy, and pharmaceuticals. The portfolio’s overall value is estimated at $125,000, split as equally as possible among the three stocks. This breakdown is summarized in Table 1.1.

Table 1.1 Model portfolio

Stock name	Symbol	Closing price *	Shares held	Total value	%
AT&T	T	$30.34	1,400	$ 42,476	33.8%
Southern Co.	SO	52.44	800	41,952	33.4
Altria	MO	51.41	800	41,128	32.8
Total				$125,556	100.0%

*Closing prices as of April 25, 2019.

Source: Charles Schwab & Co.

These companies were selected based on exceptional fundamentals (dividends, P/E, revenue and earnings, and long-term debt trends). A note concerns the fixed date: This enables comparisons between the three members of the model portfolio on the same date. However, the principles of specific trading strategies may be applied to any company on any date; even though the dates selected are outdated, this does not affect the premise of conservative trade selection and execution.

This portfolio is split equally among the three issues, a modest but effective level of diversification. An individual portfolio is likely to select an entirely different list of stocks, perhaps more than three and perhaps split in a different manner. This is only one example of how a portfolio might be diversified among several value investments (value in this sense defined as having a consistent record of increasing dividends, higher than average dividend yield, medium level of debt ratio, increasing revenues and earnings, and consistent long-term debt management).

This raises a question every investor faces: Is this a “conservative” portfolio? This is a matter of opinion and one that depends on the timing of purchase, long-term goals, and your perception about the fundamentals for each corporation. These stocks provide a cross section of stocks illustrating where strategies work well and where they do not work at all. The definition of a conservative portfolio is (and should be) always evolving based on changes in the market, in a stock’s market price and volatility and, of course, in emerging information concerning fundamental strength or weakness of a company.

The values of options for a stock will probably be consistent from one period to the next assuming that the proximity between closing price and option strike price is about the same, and that months to go until expiration are the same as well. Although these relationships vary based on ever-changing perceptions about a company, the data is valid for the purpose of illustrating strategies.

Table 1.2 Option premium, AT&T

AT&T (T)—8 days

Call or put	Strikes	Closing bid	Closing ask
C	29	1.34	1.40
	30	0.49	0.53
	31	0.07	0.09
	32	0.02	0.03
P	29	0.02	0.03
	30	0.16	0.19
	31	0.72	0.76
	32	1.66	1.71

AT&T (T) —29 days

Call or put	Strikes	Closing bid	Closing ask
C	29	1.52	1.58
	30	0.75	0.81
	31	0.25	0.30
	32	0.05	0.08
P	29	0.13	0.18
	30	0.35	0.41
	31	0.87	0.93
	32	1.68	1.74

AT&T (T)—57 days

Call or put	Strikes	Closing bid	Closing ask
C	29	1.71	1.81
	30.50	1.02	1.07
	31	0.50	0.54
	32	0.21	0.23
P	29	0.28	0.32
	30.50	0.57	0.61
	31	1.05	1.10
	32	1.75	1.81

AT&T (T)—85 days

Call or put	Strikes	Closing bid	Closing ask
C	29	1.82	1.90
	30	1.14	1.21
	31	0.64	0.68
	32	0.31	0.35
P	29	0.56	0.60
	30	0.95	0.99
	31	1.49	1.52
	32	2.22	2.29

AT&T (T)—268 days

Call or put	Strikes	Closing bid	Closing ask
C	29	2.31	2.46
	30	1.80	1.88
	31	1.34	1.40
	32	0.85	1.01
P	29	1.60	1.82
	30	2.12	2.21
	31	2.70	2.87
	32	3.30	3.45

Premium values as of April 25, 2019.

Source: Charles Schwab & Co.

The strikes and expirations for AT&T are summarized in Table 1.2 as of the date the study was conducted.

Table 1.3 Option premium, Southern Co.

Southern Co. (SO)—8 days

Call or put	Strikes	Closing bid	Closing ask
C	50	2.03	2.32
	51	1.52	1.79
	52	0.82	1.03
	53	0.29	0.35
	54	0.02	0.12
P	50	0.11	0.16
	51	0.16	0.22
	52	0.34	0.41
	53	0.75	0.89
	54	1.40	1.70

Southern Co. (SO)—29 days

Call or put	Strikes	Closing bid	Closing ask
C	50	2.59	2.95
	51	1.74	2.03
	52	1.00	1.24
	53	0.45	0.61
	54	0.15	0.29
P	50	0.28	0.35
	51	0.46	0.63
	52	0.80	0.99
	53	1.32	1.57
	54	2.03	2.36

Southern Co. (SO)—57 days

Call or put	Strikes	Closing bid	Closing ask
C	50	2.69	2.97
	52.50	0.94	1.01
	55	0.14	0.21
	57.50	0.00	0.17
P	50	0.50	0.55
	52.50	1.26	1.49
	55	2.97	3.35
	57.50	5.10	6.00

Southern Co. (SO)—113 days

Call or put	Strikes	Closing bid	Closing ask
C	50	3.00	3.25
	52.50	1.39	1.54
	55	0.44	0.58
	57.50	0.11	0.21
P	50	0.99	1.11
	52.50	1.95	2.16
	55	3.50	3.90
	57.50	5.60	6.05

Southern Co. (SO)—268 days

Call or put	Strikes	Closing bid	Closing ask
C	50	3.55	3.80
	52.50	2.09	2.32
	55	1.06	1.28
	57.50	0.48	0.59
P	50	1.89	2.08
	52.50	2.94	3.20
	55	4.40	4.70
	57.50	6.30	6.55

Premium values as of April 25, 2019.

Source: Charles Schwab & Co.

The strikes and expirations for Southern Co. are summarized in Table 1.3 as of the date the study was conducted.

The strikes and expirations for Altria are summarized in Table 1.4 as of the date the study was conducted.

Table 1.4 Option premium, Altria

Altria (MO)—8 days

Call or put	Strikes	Closing bid	Closing ask
C	50	1.69	1.82
	51	0.98	1.09
	52.50	0.30	1.36
	53	0.18	0.23
P	50	0.26	0.33
	51	0.53	0.60
	52.50	1.30	1.40
	53	1.67	1.79

Altria (MO)—29 days

Call or put	Strikes	Closing bid	Closing ask
C	50	2.17	2.52
	51	1.54	1.86
	52.50	0.78	1.07
	53	0.60	0.84
P	50	0.68	0.96
	51	0.97	1.30
	52.50	1.66	2.05
	53	2.02	2.57

Altria (MO)—57 days

Call or put	Strikes	Closing bid	Closing ask
C	50	2.53	2.90
	52.50	1.29	1.49
	55	0.51	0.62
P	50	1.36	1.57
	52.50	2.59	2.96
	55	4.40	4.85

Altria (MO)—148 days

Call or put	Strikes	Closing bid	Closing ask
C	50	3.35	3.80
	52.50	2.26	2.51
	55	0.36	0.52
P	50	2.76	2.90
	52.50	3.85	4.40
	55	5.50	5.95

Altria (MO)—268 days

Call or put	Strikes	Closing bid	Closing ask
C	50	4.15	4.60
	52.50	2.91	3.35
	55	2.06	2.40
P	50	3.90	4.35
	52.50	5.15	5.75
	55	6.75	7.35

Premium values as of April 25, 2019.

Source: Charles Schwab & Co.

The wide range of premium values is affected by both time remaining until expiration and the proximity between the strike and the current underlying stock’s price. All these values are fixed in time as of the close of business on April 25, 2019, so that comparisons between any of the three are valid.

In coming chapters, dividend yield will also be featured as a prominent part of return calculations. Following is a summary of annual yield for the three companies:

Class questions for discussion and/or mini-case studies

Multiple choice

1. The most rational method for selecting stocks to hold in a portfolio is:

   a. Buying shares in the company whose stock has risen the most during the past year.

   b. Looking for the highest volatility in price.

   c. Narrowing the field with a short list of fundamental trends over several years.

   d. Following the financial news and picking stocks the commentators like.

2. The most reliable fundamentals include:

   a. Dividend yield and the trend in long-term debt.

   b. Price changes over the past year.

   c. Price declines, which tend to be followed by price rises.

   d. Percentage of gross assets that have been depreciated.

3. A truly conservative portfolio consists of:

   a. Growth stocks.

   b. Value stocks.

   c. Volatile stocks.

   d. A combination of value and growth.

Exercise for Discussion

Select three stocks of companies with high name recognition (not including the three companies described in this chapter). Study these for a 10-year period and track dividend yield, range of PE ratio, revenue, net profit, and long-term debt capitalization. State your conclusions about whether these companies meet the fundamental criteria for including a company’s stock in your portfolio.