CHAPTER 13

Stock Selection and the Option Contract

When all possible options strategies are considered in the context of your conservative profile, what are the criteria for determining which (if any) strategies are appropriate? A recurring theme in this book is focusing on risk profiles and remaining faithful to your original conservative investing themes, limitations, and capabilities.

No options strategy is appropriate if its use requires you to alter your risk profile. However, if you discover while investigating options that you are willing and able to take on higher risks than you had assumed previously, you need to reevaluate all your underlying assumptions. The process of defining risk tolerance is an evolving process; few investors keep the same risk profile without change over time. Risk level is determined by a broad range of other matters: knowledge and experience, personal income and capital, change of job, marriage, birth of a child, divorce, death of a family member, and changes in a family member’s health.

Your Conservative Profile as a Priority

Even with a thorough grounding in options and their context, you need to continually remind yourself of your personal goals, limitations, and standards. The market is a playground full of temptations, and many well-intended investors become distracted from their sensible goals and drawn to the dangerous but exciting high-risk, exotic, and potentially profitable schemes that are so visible and popular. Conservative, fundamentally based strategies are not terribly exciting, especially in the media-focused market environment. The media tend to emphasize index movement, substantial point change in high-profile stocks, and market rumors and news. Even fundamental news like earnings reports is focused on variation between analysts’ predictions and actual outcome rather than on the value of the company as a long-term investment. This scorekeeping is the popular game on Wall Street— at the expense of less exciting but more relevant strategies based on fundamental analysis.

The market, as a media-driven “store” containing an array of products (stocks, bonds, commodities, and derivatives), is distracting. It is very much an open market with brokers tempting buyers with promises of easy riches. Little if any attention is paid to the analytical, detail-oriented fundamental study of a company’s financial statements and other financial information. Why should the media highlight a subtle change in a capitalization or working capital ratio? It is much easier to report a 2-cent variation between earnings and predictions or a 4-point movement in the stock’s price.

Pitfalls in Using Options

Options, like so many aspects of the market, offer numerous temptations. The speculator is drawn to the positive aspects: leverage of capital with the potential for fast profits, often in triple digits, and the fast pace of the market. They rarely pay attention to the other attributes of risk associated with options: equally fast losses, long-position disadvantages, and the virtual impossibility of profiting from speculation consistently.

It is easy to lose sight of your goals. You can slip out of a conservative mode, allowing risks to expand unintentionally, and become fascinated with the potential of an options strategy. The importance of testing every strategic choice against the sound, conservative risk profile you have already established in your portfolio serves as a standard for selection.

Allocation by Risk Profile

Some people believe that a sensible way to use options is to create a base in their portfolio at some percentage of capital. For example, they may devote 80 percent of their capital to conservative investments. The remaining 20 percent is “mad money,” put aside to give in to temptation and to seek high returns along with high risk. However, it is a poor policy. Why not invest 100 percent of your portfolio in high-value stocks and then use options conservatively to augment returns, protect long stock positions, and take advantage of market price overreactions? It makes more sense. You will experience consistent current yields using strategies like contingent purchase, covered calls, and short combinations (involving covered calls and uncovered puts). These uses of options do not add to market risk. Their overall theme is easily summarized: They are designed to provide conservative returns consistently over time. Of course, you will occasionally have shares of stock called away with short calls or have shares put to you with short puts, and you may lose the opportunity to make a higher profit if you had made different choices—the value of hindsight. In exchange for the occasional lost opportunity, you can modify your portfolio to create option returns, a trade-off you may view as a good choice most of the time.

These strategies must always conform to your long-term conservative risk profile. Your purpose is to build wealth, not to speculate recklessly; so the use of options must be restricted to those strategies that enhance your existing long stock positions or that expose you to the purchase of stock that you desire to own —either more shares of existing issues or shares of other stocks that have been prequalified as appropriate for your portfolio.

Some people, notably those who have not examined the conservative potential in the options market, argue against the concept that options augment the conservative attributes of your portfolio. One conclusion is impossible to avoid: Not only are some option strategies conservative, but also not employing them puts your portfolio at greater risk. For example, when a stock’s market value rises far above its normal trading range, you naturally expect a short-term correction. This is the perfect time to write covered calls. You expect the stock’s value to retreat, but if strike price is properly selected with current higher-than-expected prices in mind, exercise itself would create a substantial profit. If, instead, you buy puts for insurance, you also protect paper profits by timing your decision based on awareness of trading range versus current price spikes. The same observation is true when prices decline rapidly. A downward spike is a buying opportunity. The traditional method, buying additional shares, is a difficult decision to make when prices have fallen because you may be uncertain about short-term volatility and potential for further decline. An alternative is to buy calls or, even more conservatively, to sell OTM puts. In either event, you create the potential to buy more shares and average down your basis in the stock without placing more capital at risk through purchase of shares.

Using Options to Reduce Market Risk

The ultimate conservative approach, the short combination or short straddle explained in Chapter 8, creates a position in which even a drastic decline can be rescued with additional options positions. When you create a large protective range through the selection of options strategies, you reduce market risk rather than increase it. In many instances, just holding shares and taking no action becomes high risk, even in a conservative portfolio. The long-term approach traditionally has shunned strategies based on reaction to short-term price movement in favor of holding onto conservative growth investments. This plan works; however, average returns on a conservative portfolio are less than 10 percent. Options can help you to adhere to your conservative risk profile while also beating the market consistently.

You have heard wild promises about double-digit and even triple-digit returns by applying an investing “system” of one kind or another. Experience (meaning “loss”) has taught you that schemes do not work and that there are no easy or sure-fire ways to beat the market. Even the conservative use of options requires diligence, learning techniques, mastering terminology, and becoming more knowledgeable than the average investor. Some conservative investors are content to buy shares in blue chips and to place the balance of their capital in a moderate growth mutual fund. Although this traditional approach may enable you to experience average growth or even to outperform long-term averages, it is not spectacular.

Temptation to Select Most Volatile Stocks

When your conservative portfolio does not perform as you expect, what can you do? Some investors are tempted to sell lackluster stocks and go with more exciting, more volatile issues. The idea is that you can experience profits more rapidly, make up for past losses, and outperform the market. In fact, though, this approach is an abandonment of conservative principles. You need to continue to carefully select value stocks and then protect their equity value. This is the conservative strategy.

Investors who like the idea of using options also face danger when they pick stocks inappropriate for the conservative risk profile. If you shop option premiums with the idea of buying stock and then discounting your purchase price with covered calls, you are taking the wrong approach. A conservative application of options requires that you first select stocks based on fundamental analysis and comparison; that you pick stocks with lower-than-average volatility and potential for price appreciation; and that the capital structure, revenue and earnings, PE ratio, dividend history, and other indicators of your stocks are a good fit for your conservative standards. Then you use conservative options strategies to protect equity and enhance current income. Using conservative options strategies on risky, volatile stocks contradicts your standards. The first rule is to pick your stocks carefully and then identify methods for protecting their value.

Creating a List of Potential Investments

There is no shortage of high-quality stocks. By applying conservative principles, you can easily identify at least 10–20 stocks you would like to own. You might not be able to afford to buy shares of all of them, but it is not the point. Once you develop your list of quality growth investments, you can buy shares in several of those companies; if a covered call strategy ends up with stock called away, it is not a complete loss. The transaction frees up capital that can be reinvested in the stock of another company on your list.

You gain further flexibility in options trading when you own more than 100 shares of stock. It gives you the chance to vary the use of options, to cover partial holdings, and to change the mix of short options against long stock when you roll forward and up. You can also write covered calls with a mix of expiration and strike prices or make combinations and short straddles more flexible and interesting with a similar mix.

Creating Sensible Conservative Standards

If you accept certain options strategies as fitting within your conservative framework, it is worth asking again: What is the definition of a conservative portfolio? In other words, what are the basic standards for stock selection? You already know that picking stocks based on potential option premium levels is a mistake that should not enter the equation.

The Four Conservative Standards for Stock Selection

There are a few well-understood conservative standards for picking stocks. These should include, at the very least, the following four criteria:

1. Revenue and earnings trends. The quarterly and annual rate of growth in revenues and consistency in earnings is always a sound starting point in fundamental analysis.
2. Capitalization and working capital. If a company is depending increasingly on long-term debt to fund growth, an increasing portion of future earnings will have to go to debt service, leaving less capital for expanded operations and dividend payments.
3. PE ratio trends. The PE ratio combines technical (price) and fundamental (earnings) in a single multiplier.
4. Dividend history. The history of dividend payments and the current yield are indicators pointing to growth and working capital management.

This list is only a starting point—the bare minimum of fundamental indicators. In your conservative analysis, you may also use any number of other indicators you find useful, including a broad range of balance sheet or income statement ratios, management indicators, or combinations of fundamental and technical trends.

Maintaining Fundamental Clarity

Investors tend to believe that good values are difficult to find. However, confusion arises to define “value” in the market. Some investors think that they should buy stocks that double in value immediately after they purchase shares. This is simply unrealistic. But even conservative investors may end up chasing short-term profits and may conclude that it is difficult to find profits—by a double-in-value definition—with consistency.

Under a conservative standard, quality investment is defined as a strongly capitalized, well-managed, profitable, and competitive company whose stock has performed strongly and consistently, and whose fundamental and technical risks are a good match for your conservative profile. Under this definition, there are many good values to be found in the market. The argument against covered call writing—that you risk losing stock if exercised—is often premised on the idea that a stock, once lost, cannot be replaced. In fact, though, good values abound and can be located using fundamental criteria.

Distinctions: Risk Standards versus Brand Loyalty

The clarity with which you view your long-term goals has everything to do with how you manage your portfolio. Investors often develop a “brand loyalty” to the stocks they own. Closely related to this is an aversion to some companies based on non-investing criteria. For example, some people hate Wal-Mart or Microsoft and will never buy shares in those companies. Some investors are faithful to IBM or Pepsi. These love-or-hate opinions are not often based on fundamental analysis but on some personal, social, or political opinion. To maintain clarity, avoid investing in companies that you either love or hate, if only because strong feelings about a company can cloud judgment. You can make more objective decisions about when to buy, hold, or sell a company’s stock if you are neutral about its policies, politics, or social impact. For example, if you once owned a small retail store and you were forced out of business because Wal-Mart opened a Supercenter across the street, you may not be able to objectively evaluate the investment value of Wal-Mart stock. If you swear by Microsoft products, you might not be able to analyze the company’s ability to compete in the market.

Given the large number of excellent quality investments, it makes sense to limit your analysis to those companies that you can evaluate objectively. In stock selection as well as in a decision to employ options strategies, there is plenty of fundamental analysis to be done without struggling with personal feelings about the company itself. If you have personal conflicts about a company, avoid buying shares and restrict your search to those companies that you do not find offensive on some noninvestment level.

Once you pick companies that qualify for your fundamental, conservative standards, you also want to maintain clarity on two other levels: stock ownership and the use of options. Base the decision to hold or sell on consistency in fundamental indicators or on emerging changes in trends. One stock might be a good candidate for option strategies; this does not mean that the stock continues to qualify as part of your conservative portfolio. It makes sense to sell shares of stock as soon as the risk factors change and those factors are clear and precise, based on financial information and capital strength but not on technical aspects of option values.

The second form of clarity is the use of options. A limited number of appropriate strategies are present in your conservative portfolio, and once you have set standards limiting their use, be sure to avoid the temptation to wander from those limited, conservative applications. To review, your criteria may include the following:

1. Use options only for stocks you own or want to own.
2. Use covered calls only if you are willing to accept exercise.
3. Use short puts only if you are willing to buy additional shares, either through a contingent purchase plan or when market movement presents buying opportunities; or plan to close or roll forward to avoid exercise.
4. Premium value from writing short options should be at or greater than a minimum annualized return (e.g., you might use 10 percent as your starting point).
5. Long options should be purchased to (a) protect existing paper profits, (b) exploit unusual and temporary market movements, (c) provide cover for short option positions, and (d) average down your basis in the stock.
6. Long calls may also be used as a form of contingent purchase, but only for stocks you want to buy; it is one way to leverage capital by locking in strike prices on numerous stocks, notably when using LEAPS.
7. Writing short combinations or straddles is appropriate only when the call side is covered and when all possible outcomes have been evaluated and qualified to meet your conservative standards. To make these short positions more conservative, you can cover short put positions with lower-strike long puts, reducing overall profit but removing market risk.

The Role of Taxes in the Option Equation

Even when you have defined clear guidelines for using options in your portfolio, you may yet face complications due to the tax rules, one of the most troubling aspects of including options as a portfolio strategy. Although everyone hopes for tax simplification, history shows that reforms in the federal tax system have invariably made matters more complex.

A seemingly innocent strategy, such as a short straddle, can cause tax problems. The least of these may be deferral of losses to a future period when a second leg of a straddle closes.

Four Tax Guidelines

A more significant threat than deferral of losses is the removal of long-term capital gains status in exercised stock. Some tax guidelines include:

1. Limit covered calls to OTM positions. Using OTM calls avoids the complexities that arise when writing ITM calls.
2. Accept exposure to loss of long-term capital gains only when you have carryover losses. If you have large carryover losses, you can maximize options strategies by accepting short-term gains and sheltering them with the carryover loss.
3. Be aware of how the tax rules affect any combination strategies, especially short straddles. Be aware of how a specific strategy affects your tax liabilities and rely on your tax advisor to guide you in options taxation matters.
4. Rolling out of one position and into another could change the status of capital gains taxation. If you begin with an OTM covered call and then roll forward to a later expiring ITM position, you could trigger the loss of long-term status for the underlying stock.

Option Volatility to Judge Stocks

Tax rules complicate your portfolio. Taxes alone may prevent your entering specific types of transactions. However, knowing the tax outcome in advance provides you with better information and guidelines for proceeding. For most investors, managing market risk—usually measured by degrees of volatility—is a more immediate problem.

The temptation to buy highly volatile stocks specifically to sell covered calls is difficult to resist. But the greatest trap is to start out as a conservative investor and end up with a portfolio of inappropriate stocks. It can happen easily if your selection is based on option-specific valuation rather than on tried-and-true fundamental indicators for selection of the underlying stock. It is not necessary to stray from the conservative standard because it is not difficult to earn options-based returns through conservative strategies.

Volatility as an Early Indicator

Option volatility itself may indicate emerging fundamental problems in a company. The problems may be temporary or permanent. For example, the current quarter’s earnings may be lower than expected, which creates momentary volatility. But in the long-term, bigger picture, the company’s fundamentals have not changed. In other instances, perhaps a corporation has peaked and is now beginning a gradual downward earnings slide, loss of competitive position, or subtle changes in financial strength. If debt capitalization is inching upward as a percentage of total capitalization, for example, it could signal a change in fundamental strength. This ultimately affects dividends and erodes working capital, recognizing such changes earlier helps you to time decisions. Option volatility is not always an early indicator, but it could be. If option volatility changes suddenly, it is worth the effort to check fundamental trends, evaluate recent news or earnings reports, and look for any confirming signs that the financial strength and position of the company have changed.

Options should be viewed as alternative strategies that may augment the conservative portfolio strategy, provide alternatives to outright purchase, or enable you to protect or take paper profits without having to sell shares.

Option volatility can help you to coordinate your fundamental analysis with technical tests. Degrees of volatility provide potential confirming information or even signal coming changes. In addition to reviewing the fundamentals, technical tests of various types can be used—in conjunction with fundamental analysis—to augment your study of trends. Technical and fundamental volatility are closely related. For example, when a company reports consistent growth in revenues and earnings over time, you are likely to observe a gradual increase in stock market value within a relatively narrow trading range. When the trading range is broader or erratic compared with marketwide trends, it usually signals similar volatility in the fundamentals.

It makes sense to test a limited number of technical indicators along with your fundamentals. These may include option premium volatility as well as trading-range trends and the stock’s support and resistance levels. A comparison between fundamental and technical indicators improves your overall program and often provides greater insight than you can achieve with a program limited only to a few fundamental indicators.

The time difference between financial reports and current trends limits the isolated use of fundamentals. Since quarterly and annual reports are outdated by the time they are released, it is difficult to equate these reports to current price trends. However, emerging trends in price volatility provides an indicator of pending financial changes, just as current earnings reports have an immediate effect on the technical side.

It makes sense to consider option volatility within a coordinated fundamental plan; this is especially true if you incorporate technical indicators into your study of a company. Options have no fundamentals of their own since they are derived from the underlying activity, which is why it is so important to limit your use of options to appropriately selected stocks. A conservative portfolio’s overall return can be both protected and enhanced with options and done so in a way that remains faithful to your risk profile that is so crucial to your investing success. Avoid the mistake of using options that expose your portfolio to high risk. Isolate your options program to only those strategies that protect your portfolio or that provide premium returns without increasing market risk. As with any range of strategies, the appropriate range of possible uses of options is a short list, and it should be. Inexperienced investors are invariably surprised when they experience losses. Wiser investors know that although some losses are unavoidable, reducing the chances of loss is the key to success. Options can help achieve that while improving overall rates of return in your conservative portfolio.

Class Questions for Discussion and/or Mini-Case Studies

1. Among the pitfalls of using options in a conservative policy is:

   a. a tendency to lose more often than win.

   b. the possibility of a tax audit.

   c. moving away from true conservative decisions.

   d. loss of value in the portfolio because options expire.

2. Allocation by risk profile:

   a. requires that a portion of capital be placed at higher risks than are acceptable.

   b. is essential to protecting capital while earning a good return.

   c. may be the only way to beat the market averages.

   d. should be reserved only for financial professionals.

3. Options can be applied to reduce market risk by:

   a. well-timed covered call trades.

   b. buying puts to protect paper profits and avoid losses.

   c. opening combination strategies that conform to conservative strategies.

   d. all of the above.

Discussion

List the four primary methods for qualifying a company on a fundamental basis and explain how they work together.