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

  • Options on Options

    Traders have long known that options can be opened on many different securities. Among the most ingenious of these are options on options. There are four types of these: call on a call (CoC), a call on a put (CoP), a put on a call (PoC), and a put on a put (PoP).

    By Michael C. Thomsett,

    • 0 comments
    • 45 views
  • The Wheel Trade

    The “wheel” trade is variously described as a beginner’s strategy, a combination to exploit features of both calls and puts, and as “perfect” solution to the well-known risks of shorting calls, even when covered. The wheel could be defined as any of these, but a larger question should be: Is the wheel an elegant method for making profits consistently, or just a gimmick?

    By Michael C. Thomsett,

    • 0 comments
    • 361 views
  • Chooser Options

    Most options traders see their world as a choice between calls or puts, alone or in various combinations. But there is more. With a chooser option, traders can open a position and decide later whether it will be a call or a put. This is also called an as you like it option.

    By Michael C. Thomsett,

    • 0 comments
    • 330 views
  • Leveraged Anchor 2020 Year In Review

    Steady Options has now been trading the Leveraged Anchor strategy for two years, and, somewhat to my surprise, 2020 went even better than 2019. On the year, Leveraged Anchor was up 31.7%, while the total return of the S&P 500 was 18.4%.

    By cwelsh,

    • 2 comments
    • 1,048 views
  • Ratchet Options

    The “ratchet option” is so-called because as a series, each successive position activates when the previous option has expired. The trader ratchets up (or down) to the next position. Each one is set up to be as close to the money as possible. It has many names, including cliquet, moving strike, ladder, lock-in, or reset option.

    By Michael C. Thomsett,

    • 0 comments
    • 341 views
  • Steady Momentum 2020 Year in Review

    Steady Momentum Put Write (SMPW) is one of the available subscription services at Steady Options. We launched the strategy in early 2019, so we now have two years of performance to evaluate on both an absolute basis and relative to the strategy’s benchmark, PUTW (WisdomTree CBOE S&P 500 PutWrite Strategy Fund). 

    By Jesse,

    • 0 comments
    • 329 views
  • SteadyOptions 2020 Year In Review

    2020 marks our 9th year as a public trading service. It was an excellent year for us. We closed 130 winners out of 194 trades. Our model portfolio produced 117.1% compounded gain on the whole account based on 10% allocation per trade. We had only three losing months in 2020. 

    By Kim,

    • 0 comments
    • 614 views
  • The Jump-Diffusion Pricing Formula

    One of the more complex areas of options analysis involves pricing formulas. The best known among these is the Black Scholes Model (BSM). This is a widely cited method for attempting to determine what the option’s premium should be, but it is deeply flawed.

    By Michael C. Thomsett,

    • 0 comments
    • 374 views
  • Ranges of Exotic Options

    The standard call and put are well known to all option traders, but many exotic and more advanced options can also be opened. Whether a specific broker allows trading in these, and whether a trader has the necessary trading level, are questions to be addressed. This article just defines many of the exotic options that are possible.

    By Michael C. Thomsett,

    • 0 comments
    • 465 views
  • What To Do Before Committing To Trading

    Trading cryptocurrency has become a very popular and significant part of life. While it’s not for everyone, it’s certainly for an awful lot of people. There’s money to be made and areas to be invested in, and people will do what they can to make either a quick buck or an amazing figure.

    By Kim,

    • 0 comments
    • 610 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 Expertido