Choosing the Right Stocks

How do you pick a stock? With about 8,000 to choose from, you need to narrow down the list. When picking stocks with options in mind, you will need to combine fundamental and technical tests to ensure that you pick those stocks with the greatest potential for growth and that offer you the very best options positions.

As a starting premise, be sure to observe some basic rules for picking stocks:

  1. Always pick stocks that are strong on their own merits. A common error is to pick stocks based only on the option premium levels offered.
    This is a mistake because richer options are a symptom of higher than average stock volatility. So if you pick stocks based only on high option values, you will pick the highest-risk stocks. You will do better selecting stocks with strong fundamental and technical indicators.
  2. Combine a very short list of key indicators for stock selection. You could spend all day applying endless tests to stock selection. But in fact, you should be able to use six fundamental indicators and confirm these with an equally short list of technical tests.
  3. Avoid stocks of companies that have never reported a profit, or whose stock price has been falling over many years. As obvious as these guidelines might seem, they are often ignored. If a company is losing money each year or has never reported a profit, there is no rationale for expecting market value to grow. On the technical side, stock price trends tell the whole story. If a company has been experiencing a declining range of stock prices over many years, stay away. It usually means the company has lost its competitive edge and is on the way out.
  4. Look beyond option values; use past history of basic outcome. The "basics" are usually the most dependable indicators. You should check revenues, profits, capitalization, and cash flow to make sure management is operating the company wisely. The history of fundamental trends is the strongest collective indicator for picking strong companies.

In this article, you have a short course on the fundamental and technical indicators you need to pick strong, well-managed, and competitive companies. This is achieved with an explanation of both fundamental and technical indicators that will give you the most reliable guidance for narrowing down a list of likely stocks to buy, whether you trade options on those stocks or simply hold them for the long term. Research is the starting point.

Careful, well-researched selection is the key to consistent investing success. This is true for all forms of investing and applies to all strategies. If your stock portfolio is not performing as you expected, you might be tempted to augment lackluster profits by using options. Short-term income could close a gap to offset small losses, improve overall yields, and even recapture a paper loss. However, short-term income is not guaranteed, and poorly selected stocks cannot be converted into high performers with options. Your best chance for success in the options market comes from first selecting stocks wisely, and from establishing rules for selection and strategy that suit your individual risk tolerance. A suitable options strategy has to be a sensible match for an individual stock based on its volatility, your goal in owning it, and its original basis versus current market value.

Deciding which stocks to buy should be based on your goals and risk tolerance levels, which are part of the process of setting an investment policy for yourself. That includes defining acceptable risks and focusing on how options can and should be used in your portfolio: to speculate, enhance income, or hedge equity positions. One danger of stock market investment is the tendency among investors to follow fads. It is invariably a mistake to begin buying shares of stock after prices have risen significantly. This brings up a number of problems, however, all dealing with timing. How do you know when a price run-up is about to begin in a particular stock or sector, and once invested, how do you know when to get out?

Both of these questions involve timing and risk. When you put capital at risk, and when you decide whether to sell, you are making risk-oriented decisions. The difficulty in these core questions can be mitigated, and risks reduced, with the use of options. Options are not purely speculative; they can also be useful for reducing risk of loss as well as risk of lost opportunity.

For example, instead of buying shares today, you might consider buying calls. Even though they will expire, they require far less capital and risk exposure. On the other end—when you own stocks whose market value has risen significantly—you can buy puts to insure against unexpected losses, or sell covered calls to (a) discount your basis and (b) increase income without selling your shares.

Options can be coordinated with long-term goals as well. A portfolio of well-chosen stocks should be treated as a long-term investment and, as a general rule, stocks will hold their value over the long term whether or not you write options.

Smart Investor Tip

Value in your portfolio of stocks exists whether you sell options or not. You cannot expect to bail out poorly selected stocks by offsetting stock losses with option profits.

One of the great advantages in selling covered calls is that a minimum profit level is likely as long as you also remember that the first step always should be proper selection of the stock.

Example

A Safe Decision: You bought 100 shares of stock for $82.20 per share. At the time, you believed this would be a sound investment with excellent prospects for long-term price growth. You also considered selling a covered call and analyzed three calls, all with striking prices of 90. These expired in 4, 7, and 13 months. Premium values for these three calls were 6.10, 7.20, and 11.50. Quarterly dividends were approximately $50 at the time. (These stock, option, and dividend values are based on closing values for IBM as of December 12, 2008.) In comparing the likely outcomes for both expiration and exercise, you analyzed returns on an annualized basis.

If the call expires:
4-month7-month13-month
Call premium$610$720$1,150
Dividend50100200
Total Profit$660$820$1,350
Annualized yield if the call expires:
  • ($660 ÷ $8,220) ÷ 4 × 12 = 24.1%
  • ($820 ÷ $8,220) ÷ 7 × 12 = 17.1%
  • ($1,350 ÷ $8,220) ÷ 13 × 12 = 15.2%
If the call is exercised:
4-month7-month13-month
Call premium$610$720$1,150
Dividend50100200
Total profit on options$660$820$1,350
Capital gain ($9,000 ÷ $8,220)780780780
Total profit, stock and options$1,440$1,600$2,130
Annualized yield if the call is exercised:
  • ($1,440 ÷ $8,220) ÷ 4 × 12 = 52.6%
  • ($1,600 ÷ $8,220) ÷ 7 × 12 = 33.4%
  • ($2,130 ÷ $8,220) ÷ 13 × 12 = 23.9%
These returns—both impressive—are typical in situations where (1) you own appreciated stock, (2) exercise would be viewed as an acceptable outcome, and (3) you are interested in improving current return on stock you own without necessarily selling.
By Michael C. Thomsett
Michael Thomsett is a British-born American author who has written over 75 books covering investing, business and real estate topics.

Copyrighted 2016. Content published with author's permission.

Posted in ...