Market Volatility Risk
Understanding the nature of volatility is essential. When you use options to accompany open stock positions, you eventually realize that volatility is going to affect your equity position, and is not just a short-term profit opportunity in options. The risk feature of volatility is going to determine the safety of your portfolio.
This danger -- market volatility risk -- is especially important if you write covered calls. Selecting stocks for long-term growth as the primary means for finding investment candidates is a fundamental strategy. However, picking stocks primarily based on the richness of option premium levels is a shortsighted strategy that may lead to losses.
This is a trap for options traders. When you think about buying stock without considering the related options, you will tend to look at financial information, long-term competitive stance, the sector, management, dividend yield, and price history, among other indicators. However, when you are looking for covered call writing opportunities, it is tempting to buy 100 shares and sell an option at the same time, using the discounting effect (return from the option) as your primary consideration. If you ignore other risk elements of the stock, you invite greater risk. The more volatile stock is, the more likely it will be to lose market value in a market decline.
Smart Investor Tip
Beware the tempting rates of return available from buying stock and selling covered calls at the same time. Don't overlook the importance of analyzing the stock as a starting point, not as a subordinate point to the option's value.
The question should be, does the option discount the share price adequately to justify the higher risk? If the option profit only serves to equalize the market risk of the stock, are there more sensible alternatives? It makes more sense to purchase the stock of less volatile companies and wait out price movement, and then sell covered calls with striking prices well above your purchase price, ensuring higher profits even in the event of exercise. While this strategy is more conservative and requires time to build profits, it also avoids the problems of market volatility. Because the federal tax rules affecting capital gains also affect after-tax profits, it makes more sense to sell out-of-the-money calls than in-the-money calls, or to accept short-term gains in exchange for higher premium income.
The comparative analysis of market volatility emphasizes a stock's share price and trading range, which are technical indicators. An equally important form of volatility involves a study of trends in the financial results of the company. An analysis of fundamental volatility is a valuable method for picking stocks wisely.
Investors like predictability. You may take comfort when a company's sales increase gradually and predictably from one year to the next, and when profits remain within an expected and predictable range. This preference has led to pressure on companies to equalize earnings through accounting decisions. You will also take comfort in the low volatility of financial reports, even when this results from creative accounting treatment of a less certain reality. You may feel safe with predictable outcomes, when fundamental volatility is low.
In the real world, however, sales and profits do not materialize consistently and steadily. Actual outcome is far more chaotic. How do companies even out their results, and isn't that fraud? The generally accepted accounting principles (GAAP) rules give corporations a lot of flexibility to interpret and report their numbers.
The GAAP guidelines exist in no one place, but consist of a series of published opinions, guidelines, and regulations developed by many groups, with the American Institute of Certified Public Accountants (AICPA) serving as central authority for GAAP standards. The Financial Accounting Standards Board (FASB) develops new guidelines and also serves as a clearinghouse for rules within the auditing profession.
Smart Investor Tip
GAAP rules are broad enough that corporations can bank earnings one year and recognize them in the next, so that the results are less volatile. This is called cookie jar accounting and, as long as the justification appears to make sense, it is allowed under GAAP. In fact, because earnings are being deferred, the bending of the rules is far more acceptable than the opposite -- booking nonexistent revenues and hoping to absorb them in better sales periods of the future.
In the typical cookie jar entry, some of this year's revenues, along with corresponding costs, are deferred and set up in a liability account. These are not true liabilities, just credit-balance accounts. So the deferred credit is reversed the following year and recognized as income. This is only one of many techniques used to reduce fundamental volatility. The existence of a deferred credit does not necessarily mean manipulation has taken place. In some instances, revenue is received in advance of being earned and it is appropriate to defer it; but the account is also used at times to control reported revenues and earnings.
Inflating current results to improve an otherwise dismal operating result requires a different type of manipulation. For example, current-year expenses may be capitalized and then amortized over several years, increasing the current year's profits. Depreciation can be spread out over a longer period than normal by making an election under Internal Revenue Code rules. Or reserves set up during acquisitions can be reversed to inflate current profits.
All of these types of entries might be allowed under GAAP; but whether accountants can justify questionable interpretations or not, the fact remains that these practices are deceptive. They give you a distorted and inaccurate picture of operations. If you make investment decisions based on inaccurate or unreliable information, you are being deceived. And to the extent that stock prices are distorted by misleading accounting decisions, option values are distorted as well.
Full disclosure and application of a universal reporting standard would be desirable. Full disclosure might also mean higher fundamental volatility. While this might be unsettling, it is always better to see an accurate result than to settle for the short-term comfort you gain from low fundamental volatility. Remember, higher volatility could have a positive effect on premium levels.
Smart Investor Tip
More accurate, consistent reporting probably would also mean greater fundamental volatility. Ironically, the more honest financial statements could reflect higher than average year-to-year volatility; this could require the market to change widely held opinions about the nature of volatility and risk.