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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: 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. 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. 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.
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: 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. 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. 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. 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. 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.