SteadyOptions is an options trading forum where you can find solutions from top options traders. TRY IT FREE!

We’ve all been there… researching options strategies and unable to find the answers we’re looking for. SteadyOptions has your solution.

Stock Selection for Options Trading


Which stocks do you pick for options trading? In fact, does the underlying really matter? Many options traders ignore or overlook the critical importance of deciding which underlying to use for options trading. Focus often is on the richness of option premium as the sole factor determining which stocks to use for options trading.

This is important not only if you hold equity positions (for covered call writing, for example). Option premium is richer for some underlyings than for others, for a good reason. Higher premium points to higher volatility. In other words, higher risk.
 

No matter what forms of option strategies you employ, picking the underlying is always a reflection of your risk profile. If you are like many options traders and you rarely if ever consider the stock and the company, you could be exposing yourself to higher risks than you intend.

 

The fundamental test

Risk is not limited to option moneyness or implied volatility. It is not limited to historical volatility of the underlying either. These are all technical tests. Of equal importance are fundamental tests. Options traders often are obsessed with risk, but they might not even consider the origins of risk, the company and its fundamentals.
 

Fundamental volatility is worth checking and comparing. If a company experiences rising revenue every year and consistent net returns, this is a reliable trend and volatility is low on the fundamental side. If a company sees erratic changes each year, from high net return to a net loss, and from rising revenues to falling revenues, that is a signal of higher risk. Even though this seems far removed from option valuation, it affects the entire options market directly.
 

Five key tests of the fundamentals should be performed over a 10-year period, using the CFRA reports provided by most large brokerages. These define fundamental volatility and translate to how much risk you face in trading options: 

  1. Dividend yield and history. What is the dividend yield and how has the trend evolved? Many exceptional companies pay 3.5% to 5.0% dividend and see equally strong priced growth over time. Select high-dividend stocks for improved reliability in price. A second test is the number of years the dividend has been increased. Many companies have increased dividend per share and dividend yield every year for 10 years or more. These so-called “dividend achievers” tend to perform over time far above market averages. Dividends matter to options traders, especially those using strategies like covered calls for which equity positions are held. Dividends often represent a substantial portion of overall return from trading, and should not be overlooked in favor of other tests such as high option premium.
     
  2. P/E ratio range per year. The current P/E ratio is meaningless by itself, because it reflects the current value and not the typical value. Because P/E compares a technical factor (price) to a fundamental factor (earnings per share), the timing is always off. Price is the price today, but earnings are reported quarterly and may be out of date at the moment. For this reason, the best way to check P/E is the annual high and low levels over 10 years. Look for companies with low volatility in P/E. The moderate range between a high of 25 and a low of 10 indicates that the pricing of stock is reasonable.
     
  3. Revenue growth. A well-managed company should see higher revenue year after year. This is difficult to accomplish over a 10-year period, so some flexibility is necessary. The cyclical nature of many sectors makes it practical to look at overall growth and not to demand that every year’s revenue should rise.
     
  4. Earnings growth and net return. There are two key earnings test. First, look for the dollar amount of earnings to increase each year. Second (and more important), check net return. This is the dollar amount of earnings divided by revenues. Expect to see a consistent net return over many years. A growing net return is not realistic; but the combination of higher dollars of net and consistent net return define good management. A company whose revenues are rising but whose net return is falling, is not being well managed.
     
  5. Debt to total capitalization ratio. This might be the most important of all fundamental tests. Total capitalization consists of long-term debt plus net equity. The ratio tracks the debt portion. If this is rising year after year, it is a red flag, indicating poor cash management and trouble in the future. As a company relies more on debt to fund dividends and future growth, less future profits will be available. Most cash management testing relies on the simple current ratio (comparing current assets to current liabilities). This is an inadequate test than can be easily manipulated by planning the timing to pay liabilities. It hap[pens too often that a company declares higher dividends and pays for those dividends by accumulating ever higher long-term debt. Look for companies with steady or declining debt ratios and avoid those with ever higher debt year after year.

 

The testing of fundamentals as a first step in picking stocks for options trading is the only way to ensure that an options program is a sound match for the trader’s risk profile. Too often, options traders express disdain for the fundamentals, thinking of them as outdated and of no use in setting up an effective trading program. Those same traders often are perplexed when trading profits fail to materialize.

By controlling the fundamental risks (volatility) by the companies selected for options trading, the historical volatility of stock and implied volatility of options will be a good match for your risk profile. If you prefer high-risk in speculative issues, pick fundamentally volatile stocks; but if you seek consistency and moderate stock and option volatility, look for the same characteristics in the fundamentals of the companies you pick for options trading.

 

Ultimately, a successful options program cannot be random or based on picking high-risk strategies on highly volatile underlyings. The relationship between the fundamental side and the technical (stock prices) determines the risk level in the options traded.

 

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 website at Thomsett Guide as well as on Seeking Alpha, LinkedIn, Twitter and Facebook.    

 

What Is SteadyOptions?

Full Trading Plan

Complete Portfolio Approach

Diversified Options Strategies

Exclusive Community Forum

Steady And Consistent Gains

High Quality Education

Risk Management, Portfolio Size

Performance based on real fills

Try It Free

Non-directional Options Strategies

10-15 trade Ideas Per Month

Targets 5-7% Monthly Net Return

Visit our Education Center

Recent Articles

Articles

  • Where to Find Exceptional Trading Data?

    Options traders are “data wonks,” meaning we all rely on information to make what we hope are informed decisions. But how do you know the difference between valuable and reliable data on the one hand, and rumor or speculation on the other?

    By Michael C. Thomsett,

    • 0 comments
    • 30 views
  • Option Equivalence

    Some option positions are equivalent – that means identical profit/loss profiles – to others. Others are not. A few days ago I had an inquiry from a person trading options in a restricted account (e.g. an IRA that did not allow marginable trades or short options positions):

    By cwelsh,

    • 0 comments
    • 126 views
  • Investment Ideas for Conservative Investors

    Investors with low willingness or need to take risks often look to bank and/or life insurance company fixed-rate products to increase potential returns instead of leaving their money in conventional checking or savings accounts. Some of these product types are CD’s, structured notes, fixed annuities and fixed indexed annuities.

    By Jesse,

    • 0 comments
    • 184 views
  • iVolatility Tools: Advanced Ranker

    Here is one of the analytical tools that allows us to claim "In options we are Big Data!" For those who want to find the movers and shakers, Advanced Ranker does the job. The Advanced Ranker combines an easy to use interface with a powerful sorting logic built on IVR and IVP.

    By Levi Ioffe,

    • 0 comments
    • 159 views
  • Two Pre-earnings Momentum Trades With a Technical Trigger in Alphabet

    Both option trading backtest approaches rely on the fact that there has been a bullish momentum pattern in Alphabet stock 7 calendar days before earnings. Further, we use moving averages as a safety valve to try to avoid opening a bullish position while a stock is in a technical break down, like the fourth quarter of 2018. 

    By Ophir Gottlieb,

    • 0 comments
    • 350 views
  • Flaws in Implied Volatility

    A technical study of chart patterns, focusing on historical volatility of the underlying, reveals that depending on implied volatility is a flawed idea. Traders should remember that options are derivatives, meaning their premium value is derived from historical volatility.

    By Michael C. Thomsett,

    • 0 comments
    • 410 views
  • 7 Trading Cliches For Novice Traders

    Trading is a tough business. There is no easy money in the stock market, but there are a lot of folks who will easily take your money. What is important to know that no matter how experienced you are, mistakes will be part of the trading process. This article should help you to avoid some of those mistakes.

    By Kim,

    • 0 comments
    • 377 views
  • Iron Condor vs. Iron Butterfly

    Iron Condor and Iron Butterfly are both very popular strategies. Both of them are usually used as non-directional strategies (although butterflied can be used as a directional trade as well). Both trades are vega negative and gamma negative, but there are also few important differences between those two strategies.

    By Kim,

    • 0 comments
    • 386 views
  • Leveraged Anchor: A Three Month Review

    Steady Options has now been tracking the Leveraged Anchor from the unlevered version for three months.  The results so far have substantially beat expectations, though there is a possibility for improvements discussed at the end of this piece. 

    By cwelsh,

    • 10 comments
    • 1,098 views
  • How a Fund is Developed

    Many individuals are curious as to the testing process for a new fund.  With the plethora of funds continually being developed, having some insight into this process can be helpful for investors.  At the very least, it can provide a series of questions which should be asked in conducting due diligence on fund managers.

    By cwelsh,

    • 0 comments
    • 309 views

  Report Article

We want to hear from you!


There are no comments to display.



Create an account or sign in to comment

You need to be a member in order to leave a comment

Create an account

Sign up for a new account. It's easy and free!


Register a new account

Sign in

Already have an account? Sign in here.


Sign In Now

Options Trading Blogs