Selecting Stocks for Call Writing
Smart Investor TipUsing high-volatility stocks as a vehicle for producing current income from call writing is an appropriate strategy -- as long as you accept the higher than average risks that go along with this strategy.
You eliminate the first, third, and last choices because call premium is under 10 percent, and decide to buy the second stock on the list. It is selling at $28 per share and call premium is 3.50, a yield of 12.5 percent. This is the highest yield available from the list. On the surface, this study and conclusion appear reasonable. The selection of the call premium discounts the stock's basis by 12.5 percent. However, there are a number of problems in this approach. Most significant is the fact that no distinction is made among the stocks other than call price and yield. The selected issue was not judged on its individual fundamental nor technical merits. Also, by limiting the selection to stocks selling at $40 per share or lower, the range of potential choices is too restricted. It may be that with only $4,000 available, you would do better to select a stock on its own merits and wait until you are able to build up your portfolio.
You have only $4,000 to invest, so you limit your review to stocks selling at $40 per share or less. Your objective is to locate stocks on which call premium is at least 10 percent of current market value of the stock, with calls at the money or out of the money. You prepare a chart summarizing available stocks and options:
ExampleJudging the Return: You decide to buy stock based on the relationship between current call premium and the price of the stock.
|Current Value||Call Premium|
The method in the preceding case also failed to consider time until expiration. You receive higher premiums when expiration dates are further away, in exchange for which you lock in your position for more time -- meaning more change in the underlying stock's market value will be possible. Another flaw is that these calls were not judged in regard to the distance between striking price and current market value of the stock. The yield, by itself, is a misleading method for selecting options.
Covered call writing is a conservative strategy, assuming that you first understand how to pick high-quality stocks. First and foremost should be a stock's investment value, meaning that option yield should not be the primary factor in the selection of stocks in your portfolio. On the contrary, if you are led by the attractiveness of option premium levels, you are likely to pick highly volatile stocks. If you first analyze the stock for investment value, timeliness, and safety, the option value may then be brought into the picture as an additional method for selecting between otherwise viable investment candidates.
Smart Investor TipPicking options based on yield alone is a popular but flawed method. It fails to recognize far more important considerations, such as the quality of the underlying stock, time until expiration, and the point distance between current market value and striking price. All of these variables affect the comparison.
By Michael C. Thomsett