A Reliable Method for Picking the Underlying

Once you decide on a favorite strategy or group of strategies, which underlying do you pick? Very little is said about this among traders, and it appears that many have a few favorite stocks they use for options trading. This can be based on many factors, including past experience and levels of success. Many options traders focus on positions like covered calls and limit their trades to positions held in their portfolios. This ultra-conservative approach makes sense but easily overlooks the flexibility of other strategies with similar risk profiles, such as uncovered puts. The risks are the same, but the uncovered put is far more flexible because owning equity positions is not part of the strategy.
 

However, if you are one of those traders focused only on the strategy, how do you pick the underlying? One method is preferable over all others: Dividend yield and history.

This is true even if you do not own stock. Clearly, a higher dividend yield is preferable over an underlying with a low-yielding dividend or that pays no dividend at all. But beyond this, it may also make sense to pick high-yielding dividend stocks and to also focus on dividend achievers, those companies increasing their dividend per share every year for at least the last 10 years. Why is this?

Although there are exceptions, dividend achievers tend to exhibit out-performance by the share price compared to the rest of the market. These also tend to show lower volatility and to provide strength in both fundamental and technical indicators. Dividend achievers provide greater benefits than dividend per share. That measure may itself be deceptive if the growth is minimal compared to increases in net earnings. Based on the payout ratio, a dividend achiever might not keep pace with profitability. For this reason, options traders will make the best selection of underlying issues when they look at all three dividend indicators:

1. Dividend yield should be better than the average stock. This is a matter of opinion, but look for stocks yielding 3.5% or higher, representing a strong return and a major part of overall returns among three sources (dividends, option premium and stock appreciation). The dividend often is the strongest of these three.
    
2. Payout ratio, the percentage of profits paid out in dividends. This is a difficult indicator because when profits are volatile, the ratio itself might jump up or down each year, so that it is not always reliable. But avoid issues exhibiting a general slide in the payout ratio over many years, a sign that management is giving shareholders only a minimal dividend when they could be sharing profits more generously.
    
3. Dividend achiever status, an increase in dividends per share every year for at least 10 years. This matters only when viewed in context of the other two dividend tests. The increase itself can mean much less when viewed by itself and not also considering where it all fits together.

There is also a fourth test worth applying. The debt-to-capitalization ratio is crucial to judging dividends and picking underlyings to trade options. Capitalization represents the sources of capital, namely long-term debt and shareholders’ equity. As the ratio grows over the years, more and more of future profits will have to be used for debt service, meaning less profits will be left to pay dividends. A strong, well managed company will report consistent or declining debt-to-cap ratios. When the ratio rises, it is a danger signal, demonstrating that management is not controlling working capital effectively.
 

Many people do not see the relationship between long-term debt and dividends. But imagine this scenario: Profits are flat or even falling, but the dividend per share is increased. How is this even possible?

It could mean that the company is allowing long-term debt to increase. That extra money borrowed is used to pay a higher dividend. Whenever profits are flat, but dividends rise, look at the debt-to-cap ratio. If it is going up each year, the positive-looking dividend history is a false signal. Eventually the company will have to pay for its over-reliance on debt. If you’re not sure about this, look back at the history of Eastman Kodak, General Motors or Sears. They all fell into the trap of letting long-term debt run away and move above 100 percent of total equity (meaning equity value was less than zero). For options trading, it might still be possible to make a profit in the short term, but over time it tends to go downhill along with the stock price.

Options trading relies on both technical indicators and fundamental trends, despite a popular belief that you can learn all you need from implied volatility and pricing models. Nothing could be so deceiving as this belief, and on the popularity of signals that reveal only part of the larger picture. Options trading is not so far rem oved from stock analysis and corporate strength (or weakness) that you can ignore it completely.
 

The broader your sources of information, the better your track record will be in trading options. There are few if any indicators that can be used on their own and without looking at related signals and trends. Picking the underlying is not just a matter of richer than average options as the means for selection. Turning to the three dividend signals plus trends in long-term debt and total capitalization, give out a complete picture of what is taking place, and this leads to more informed decisions.
 

Too many traders shun fundamental analysis when picking underlying issues for options trading. But this is invariably a mistake. More information leads to better decisions.

Michael C. Thomsett is a widely published author with over 80 business and investing books, including the best-selling Getting Started in Options, coming out in its 10th edition later this year. He also wrote the recently released The Mathematics of Options. Thomsett is a frequent speaker at trade shows and blogs on his websiteat Thomsett Guide as well as on Seeking Alpha, LinkedIn, Twitter and Facebook.