How does averaging up help you as a call writer? When you write calls on several-hundred-share lots of stock, you are concerned about the possibility of falling stock prices. While price decline means you will profit from writing calls, it also means your stock loses value. Covered call writing provides downside protection, but that is limited; if price decline extends beyond the discounted basis of stock, then you have a problem. The more shares you own of a single stock, the higher this risk. For example, if you are thinking about buying 600 shares of stock, you can take two approaches. First, you can buy 600 shares at today’s price; second, you can buy 100 shares and wait to see how market values change, buying additional lots in the future. This means you will pay higher transaction costs, but it could also protect your stock’s overall market value. By averaging your investment basis, you spread your risk.

average up

a strategy involving the purchase of stock when its market value is increasing. The average cost of shares bought in this manner is consistently lower than current market value, enabling covered call writers to sell calls in the money when the basis is below the striking price.

TABLE 7.1 Averaging Up

Example

A Law of Averages: You buy 100 shares on the 10th of each month, beginning in January. The price of the stock changes over six months so that by June 10, your average basis is $29.50.

This example, as illustrated in Table 7.1, allows you to reduce stock investment risk. The average price is always lower than current market value as long as the stock’s price continues moving in an upward trend. Buying 600 shares at the beginning would have produced greater profits. But how do you know in advance that the stock’s market value will rise?

Averaging up is a smart alternative to placing all of your capital at risk in one move. The benefits to this approach are shown in Figure 7.1.

By acquiring 600 shares over time, you can also write six calls. Because your average basis at the end of the period is $29.50 and current market value is $32 per share, you can sell calls and with a striking price of 30 win in two ways:

1. When the average price of stock is lower than striking price of the call, you will gain a profit in the event of exercise.

2. When the call is in the money, movement in the stock’s price is matched by movement in the call’s intrinsic value.

FIGURE 7.1 Example of averaging up.

What happens, though, if the stock’s market value falls? You also reduce your risks in writing calls if you average down over time. An example of this strategy is summarized in Table 7.2.

When a stock’s market value falls, selling calls may no longer be profitable; you may need to wait for the stock’s price to rebound. This does not mean that selling calls on currently owned stock is a bad idea; a decline would affect portfolio value whether you wrote calls or not. In fact, if you do write calls, you discount the basis of stock, mitigating the effect of a decline in market price of stock. A decline that is only temporary has to be waited out because it makes no sense to set up a losing situation. You should never sell covered calls if exercise would produce an overall loss.

average down

a strategy involving the purchase of stock when its market value is decreasing. The average cost of shares bought in this manner is consistently higher than current market value, so a portion of the paper loss on declining stock value is absorbed, enabling covered call writers to sell calls and profit even when the stock’s market value has declined.

Smart Investor Tip

When the stock’s market value declines, selling covered calls is less likely to produce profits. Never write calls when exercise will produce a net loss.

In this situation, selling calls out of the money may also fail to produce the premium level needed to justify the strategy. When stock has lost value, wait for its price to recover; meanwhile, if you continue to believe the stock is a worthwhile long-term hold, acquire more shares through averaging down.

TABLE 7.2 Averaging Down

Example

Reducing the Basis: You buy 100 shares of stock each month, beginning on July 10, when market value is $32 per share. By December, after periodic price movement, the current market value has fallen to $24 per share. Average cost per share is $29.

Your average cost is always higher than current market value in this illustration using the average down technique, but not as high as it would have been if you had bought 600 shares in the beginning. The dramatic difference made through averaging down is summarized in Figure 7.2.

When you own 600 shares, you can write up to six covered calls. In the preceding example, average basis is $29 per share. By writing calls with striking price of 30, you gain one point of capital gain on the total of 600 shares in the event of exercise. This demonstrates how averaging down can be beneficial to call writers in the event that the stock’s market value falls.

FIGURE 7.2 Example of averaging down.

Averaging up and down are important tools that help you to mitigate the effects of quickly changing stock prices. In a fast-moving market, price changes represent a problem to the call writer, since locked-in positions cannot be sold without exposing yourself to greater risks in the short call position. Both techniques are forms of dollar cost averaging . Regardless of price movement, averaging protects capital. A variation of dollar cost averaging is the investment of a fixed dollar amount over time, regardless of per-share value. This is a popular method for buying mutual fund shares. However, in the stock market, direct purchase of stock makes more sense when buying in round lot increments.

dollar cost averaging

a strategy for investing over time, either buying a fixed number of shares or investing a fixed dollar amount, in regular intervals. The result is an averaging of overall price. If market value increases, average cost is always lower than current market value; if market value decreases, average cost is always higher than current market value.

By averaging out the cost of stock, you reduce exposure to loss in paper value of the entire investment. For the purpose of combining stock and option strategies, owning several hundred shares is a significant advantage over owning only 100 shares. Transaction costs involving multiple option contracts are reduced; in addition, owning more shares enables you to use many more strategies involving options. For example, if you begin by selling one call, you can avoid exercise by rolling up and increasing the number of calls sold. This provides you with more premium income as well as avoiding exercise, even when the stock’s market value is rising. By increasing the number of options sold with each subsequent roll-up, you can increase profits over time. The technique is difficult, if not impossible, when you own only 100 shares of stock.

Analyzing Stocks

Stock selection is the starting point for covered call writing. Options are valued based upon market value of the stock in comparison to striking price and expiration date of the option. So options do not contain any fundamental or technical features of their own.

Smart Investor Tip

Don’t look for fundamental or technical indicators in option; instead, study the attributes of the underlying stock.

Avoid the mistake of failing to question whether the particular stock is a good match for you, given your risk tolerance level, long-term investing goals, and available capital. Options traders are especially vulnerable to the temptation to buy stocks for the wrong reason—namely, to take advantage of high-priced option opportunities.

Risks are unavoidable attributes of investing. To spot excessive risks, follow these general rules of thumb:

• If the information provided by the company is too complicated to understand, you should not invest . In the past, some of the explanations provided by management or disclosed in footnotes were so obscure that they could not be understood, even by expert analysts. This is a danger sign.

• If a stock continues to rise beyond reasonable expectations, it could be a sign of trouble. It is rarely a good idea to buy shares in a company just because the stock’s price has risen to impressive levels. Are those levels justified by earnings?

• You need to apply tests that look beyond personal recommendations, rosy estimates of future earnings, and other suspicious indicators. Recommendations coming from analysts, stockbrokers, friends and relatives, and anyone else, should be reviewed with great suspicion. You are better off investigating companies on your own, remembering that free advice may be more expensive than the kind you pay for.

• Methods for valuing companies have to go beyond the traditional—and overly optimistic—tests so common in the market. Question traditional assumptions and methods for picking companies. Study ratios and trends in accounts receivable, bad debt reserves, inventory levels, current and long-term liabilities, and capital assets.

• Intelligent analysis has to be based on valuing companies rather than identifying target price and earnings levels. You might be comfortable with short-term forecasting, at the expense of longer-term analysis, which can be a problem. Analysts pick target trading ranges or prices for stocks as well as earnings per share, based on anything but fundamental information. Instead of predicting price-related value in the next three months, analysts should be studying and reporting on the value of companies over the next 5 to 10 years.

core earnings

as defined by Standard & Poor’s, the after-tax earnings generated from a corporation’s principal business.

Standard & Poor’s has changed its method for valuing companies, and its revised definition of core earnings is helpful in getting around many of the creative methods used in the past to inflate earnings and mislead investors. The S&P definition of core earnings is “the after-tax earnings generated from a corporation’s principal business.”

Smart Investor Tip

Calculating core earnings does not mean noncore line items disappear; but in calculating long-term trends, only core earnings should be considered. The noncore items are one-time occurrences and are not relevant to your fundamental trend.

Under this definition, many items are excluded from earnings, including nonrecurring gain or loss from the sale of capital assets, pro forma earnings such as gains on pension investments, and fees related to mergers and acquisitions. In the past, the inclusion of these items inflated reported profits, so that the market had unrealistic and inaccurate ideas of a company’s operating results.

The definition includes many expenses and costs that have been excluded or capitalized in the past, such as restructuring charges, write-down of amortizable operating assets, pension costs, and purchased research-and-development costs. One of the most substantial and glaring flaws of the past has been leaving out employee stock option expense, which can be a huge number; but that flaw is gradually changing as many corporations have begun expensing stock options granted each year. As long as corporations left these and similar items out of the picture, stockholders were given a very unrealistic view of operations.

pro forma earnings

“as a matter of form” (Latin), a company’s earnings based on estimates or forecasts with hypothetical numbers in place of known or actual revenues, costs, or earnings.

Smart Investor Tip

Standard & Poor’s provides many useful articles and reports concerning core earnings. Check www2.standardandpoors.com and then search on “core earnings” to find a current list of articles.

The move by S&P to arrive at a standardized definition of the real earnings number is a positive trend. It enables like-kind comparisons between many different corporations, without the very real concern for inconsistent treatment and interpretation of revenues or costs and expenses. The S&P definition makes more sense than the more widely used EBITDA, which is earnings before interest, taxes, depreciation, and amortization. EBITDA was originally intended to serve as a measurement of cash flow or cash-based earnings for a company; however, this measurement is flawed.

EBITDA

a popular measurement of cash flow, an acronym for earnings before interest, taxes, depreciation, and amortization.

Under EBITDA, no provision is included to account for purchasing of capital assets or paying down debts. Rather than a clarifying calculation, EBITDA has been used more as a way to make things appear better than they are. For example, when accounts receivable levels are rising, EBITDA does not make a distinction between cash sales and credit sales—an area where revenues have been exaggerated in some cases and where it is all too easy to alter the true numbers to inflate earnings.

Smart Investor Tip

EBITDA, a well-intended calculation, has been widely misused to distort the numbers. For this reason, it should be rejected as a formula in your analytical study of a company.

quality of earnings

a measurement of the reliability of financial reports. A high quality of earnings means the report reflects the real and accurate operations of a corporation and may be used reliably to forecast likely future growth trends.

As a starting point in the analysis of corporate reports, identifying core earnings helps you to analyze many different companies on a truly comparative basis. Going beyond that, you also need to quantify what analysts call the quality of earnings. While this term has many definitions, it is supposed to mean earnings that are reliable and true, as opposed to those that are overly optimistic or inflated. For example, if a company reports income based on accounts receivable that might never be collected, that is not a good quality of earnings. The definition should include revenues that are likely to be collected and not created out of accruals, acquisitions, or accounting tricks.

In addition to the importance of selectively identifying companies based on quality of earnings, make use of specific fundamental tests. Fundamental analysis—the study of financial information, management, competitive position within a sector, and dividend history, for example—provides you with comparative analysis of value, safety, stability, and the potential for growth in the stock’s long-term value. Financial and economic information, corporate management, sector and competitive position, and other indicators involving profit and loss, all are part of fundamental analysis. The fundamentalist studies a corporation’s balance sheet and income statement to judge a stock’s long-term prospects as an investment. Other economic indicators may influence your decision to invest or not.

The fundamentals should be reliable. If we cannot rely on what is being reported, what good is any form of analysis? Any study involving the fundamentals has to involve analysis on two levels. The traditional level includes trend analysis, for the purpose of identifying changes in financial strength and competitive position. Second is an equally important study of financial ratios, for the purpose of ensuring that a company is not artificially inflating earnings in order to deceive investors.

The fundamental analyst believes in the numbers. However, part of a scientific analysis has to include verification of the core data as a starting point. The fundamental analyst has to be able not only to interpret the information, but also to use some basic forensic accounting skills to make sure the numbers are real. Those skills include a study of the basic ratios in a search for suspicious or questionable changes. If such changes are discovered and not adequately explained, that discovery is a warning that something could be wrong.

The technician will be less interested in the forensic aspects of current or past information. Technical analysis involves a forward-looking study relating almost exclusively to price of the stock, market forces affecting that price, and anticipation of changes based on supply and demand, market perception, and trading ranges. The technician uses financial data only to the extent that it affects a current price trend, believing that this trend provides the key to anticipating the future price movement of stock. Market analysts believe that price change is random, especially short-term price movement; but some technicians, notably the chartist, prefer to believe that patterns of price movement can be used to predict the direction of change in the stock’s price.

The fundamental approach is based on the assumption that short-term price movement is entirely random and that long-term value is best identified through a thorough study of a corporation’s financial status. The technical approach relies on patterns in price of the stock and other price-related indicators associated more with the market’s perception of value and less with financial information. Obviously, a current report on the corporation’s net income will affect the stock’s market price, at least temporarily, and technicians acknowledge this. However, their primary interest is in studying pricing trends.

chartist

an analyst who studies charts of a stock’s price movement in the belief that recent patterns can be used to predict upcoming price changes and directions.

Both theories have value, so it makes sense to apply fundamental and technical analysis in your analytical program. You monitor the market to make the four important decisions: buy, hold, sell, or stay away. Analysis in all of its forms is a tool for decision making, and no analysis provides insights that dictate decisions exclusively. Common sense and judgment based on experience are the extra edge that you can bring to your investment decisions. Successful investing is the result of being right more often than being wrong.

Smart Investor Tip

There are no formulas that will make you right all of the time. Investing success comes from applying good judgment, increasing your chances of being right about market decisions.

Never overlook the need to continuously track your stocks. Call writers may be inclined to ignore signals relating to the stock when, if they were not involved with writing options, they might tend to watch their portfolio more diligently. Call writers are preoccupied with other matters: movement in the stock’s price (but only insofar as it affects their option positions); chances of exercise and how to avoid or defer it; opportunities to roll forward; and other matters concerning immediate strategies. As important as all of these matters are for call writers, they do not address the important questions that every stockholder needs to ask continuously: Should I keep the stock or sell it? Should I buy more shares? What changes have occurred that could also change my opinion of this stock?

The time will come when, as a call writer, you will want to close an open call position and sell the stock. For example, if you own 100 shares of stock on which you have written several calls over many months or years, when should you sell the stock and get out? For a variety of reasons, you might conclude that the stock is not going to hold its value into the future as you once believed. Even if you buy stocks for the long term, you may need to rethink your positions through constant evaluation, whether you write calls or not. It would be a mistake to continue holding stock because it represents a good candidate for covered call selling, when in fact that stock no longer makes the grade based on the analytical tests that you use to pick stocks as a starting point.

Fundamental Tests

A number of fundamental indicators are useful in deciding when to buy or sell stock; these tests should always override the attributes in the options. Remember, options are always related to stock valuation, and trying to make profit through options on stocks that are not worthwhile investments is a losing strategy. A worthwhile investment has to be defined as one containing fundamental strength: revenues and earnings, dividend history, and capitalization.

One indicator that enjoys widespread popularity is the price/earnings ratio (P/E ratio). This is a measurement of current value that utilizes both fundamental and technical information. The technical side (price of a share of stock) is divided by the fundamental side (earnings per share of common stock) to arrive at P/E.

price/earnings ratio

a popular indicator used by stock market investors to rate and compare stocks. The current market value of the stock is divided by the most recent earnings per share to arrive at the P/E ratio.

earnings per share

a commonly used method for reporting profits. Net profits for a year or for the latest quarter are divided by the number of shares of common stock outstanding as of the ending date of the financial report. The result is expressed as a dollar value.

Example

Calculating the P/E: A company’s stock recently sold at $35 per share. Its latest annual income statement showed $220 million in profit; the company had 35 million shares outstanding. That works out to a net profit of $6.29 per share: $220 ÷ $35. The P/E ratio is

$35 ÷ $6.29 = 5.6

Example

A Second Calculation: A company earned $95 million and has 40 million shares outstanding, so its earnings per share is $2.38. The stock sells at $28 per share. The P/E is calculated as

$28 ÷ $2.38 = 11.8

The P/E ratio is a relative indicator of what the market believes about the particular stock. It reflects the current point of view about the company’s prospects for future earnings. As a general observation, lower P/E ratio means your risks are lower. Any ratio is useful only when it is studied in comparative form. This means not only that a company’s P/E ratio may be tracked and observed over time, but also that comparisons between different companies can be instructive, especially if they are otherwise similar (in the same sector or same product profile, for instance). In the preceding examples, the first company’s 5.6 P/E would be considered a less risky investment than the second, whose P/E is 11.8. However, P/E ratio is not always a fair indicator of a stock’s risk level, nor of its potential for future profits, for at least six reasons:

1. Financial statements may themselves be distorted. A company’s financial statement may be far more complex than it first appears, in terms of what it includes and what it leaves out. Conventional rules for reporting revenues, costs, expenses, and earnings may not convey the whole picture, and a more in-depth analysis of core earnings is an important step to take.

2. The financial statement might be unreliable for comparative purposes. Companies and their auditors have considerable leeway in how they report income, costs, and expenses, even within the rules. This makes valid comparison between different companies problematical.

3. The number of shares outstanding might have changed. Because shares outstanding is part of the P/E ratio equation, its comparative value can be affected when the number of shares changes from one year to another.

4. The ratio becomes inaccurate as earnings reports go out of date. If the latest earnings report of the company was issued last week, then the P/E ratio is based on recent information. However, if that report was published three months ago, then the P/E is also outdated.

5. The P/E itself involves dissimilar forms of information. The P/E ratio compares a stock’s price—a technical value based on perceptions about current and future value—with earnings, which is historical and fundamental in nature. This raises the question about whether a purely technical matter such as market price can even be compared to a purely historical and fundamental matter such as earnings, or how much weight this indicator should be given in evaluating a stock.

6. Perceptions about P/E ratio are inconsistent. This indicator is widely used and accepted as a means for evaluating and comparing stocks. However, not everyone agrees about how to interpret P/E itself.

How should you use the P/E ratio? It is a valuable indicator for measuring market perception about value of a stock, especially if you are tracking the P/E ratio for a single stock and watching how it changes over time. Comparing P/E between two different stocks may be more of a problem in terms of reliability. Companies in different industries, for example, may have widely different norms for judging profits. In one industry, a 3 percent or 4 percent return on sales might be considered average, and in another an 8 percent return is expected. So comparing P/E ratios between companies with dissimilar profit expectations is inaccurate.

The proper use of P/E can be based on comparisons between companies. Remember, the P/E represents a multiple that price resides above annual earnings. So when the P/E is at 10, that means current price is 10 times annual earnings per share. A P/E between 10 and 20 is usually considered “reasonable” by most investors’ standards. But multiple when P/E rises to 50 or 60 (or higher), it is clear that the current price has become unrealistic.

multiple

The P/E’s outcome, the number of times current price per share is above annual earnings per share; for example, if the P/E is 10, then current price per share is 10 times higher than the latest reported earnings per share.

The P/E can provide useful information as long as you also recognize its limitations. A more practical and tangible indicator is dividend yield. This is expressed as percentage of the share price. As the stock’s market price changes, so does the yield. Compare:

dividend yield

dividends paid per share of common stock, expressed as a percentage computed by dividing dividend paid per share by the current market value of the stock.

$3.50 ÷ $65 per share = 5.4%

$3.50 ÷ $55 per share = 6.4%

$3.50 ÷ $45 per share = 6.8%

A larger dividend yield could reflect a buying opportunity at the moment. That yield, added to capital gains as well as returns from selling covered calls, could add up to a very healthy overall return. Like comparisons between P/E ratios, the dividend yield is a useful indicator for narrowing the field when you are choosing stocks for investment.

profit margin

the most commonly used measurement of corporate operations, computed by dividing net profits by gross sales.

A corporation’s profitability is another important test. Long-term price appreciation occurs as the result of the corporation’s ability to generate profits year after year. Short-term stock price changes are less significant when you are thinking about long-term growth potential of the stock, and for that, you want to compare profit margin from one company to another. This is the most popular system for judging a company’s performance. It is computed by dividing the dollar amount of net profit by the dollar amount of gross sales. The result is expressed as a percentage.

The profit margin, as useful as it is for comparative purposes between companies, and for year-to-year analysis, often is not fully understood by people invested in the market. As a consequence, many market analysts as well as investors develop unrealistic expectations about profit margin. Two points worth remembering:

1. An “acceptable” level of profit varies between industries. One industry may experience lower or higher average profit margin than another. This makes it impractical to arrive at a singular standard for measuring profitability; the unique aspects of each sector should be used to differentiate between corporations. Comparisons should be restricted to those between corporations in the same sector.

2. It is not realistic to expect that a particular year’s profit margin should always exceed that gained in the previous year. Once a corporation reaches what is considered an acceptable and realistic profit margin, it is unrealistic to expect it to continuously grow in terms of higher percentage returns.

total capitalization

the combination of long-term debt (debt capital) and stockholders’ equity (equity capital), which in combination represents the financing of corporate operations and long-term growth.

Another very important fundamental indicator is the test of total capitalization. Corporations pay for operations through equity (stock) and debt (bonds and notes). Stockholders are compensated through dividends and capital gains, whereas bondholders are paid interest and, eventually, get their entire investment repaid. An important point for stockholders to remember is that as debt capitalization increases, a growing portion of operating profit has to be paid out in interest. That means that, in turn, there remains less profit available for dividends. The debt ratio tracks long-term debt as a percentage of total capitalization. (This indicator may also be referred to as the debt-equity ratio or the debt-to-equity ratio.) If the debt portion of capitalization increases steadily over time, stockholders lose out as their dividend income is eroded. A secondary consequence is the erosion of market price resulting from ever-growing reliance on debt capitalization.

debt ratio

a ratio used to follow trends in debt capitalization. To compute, divide long-term debt by total capitalization; the result is expressed as a percentage.

These examples of fundamental indicators are important, but they do not provide the entire picture. No single indicator should ever be used as the sole means for deciding what actions to take in the market. Fundamental analysis should be comprehensive. You can employ combinations of information, including a thorough study of all of the tests that reveal trends to you. They may confirm a previous opinion, or they may change your mind. Either way, the purpose in using the fundamentals is to gather information and then to act upon it.

You should be able to judge a company based on its fundamentals by studying 10 years’ history of P/E ratio ranges; earnings per share; dividend yield; profit margin; total capitalization; and debt ratio. With these six tests, you have a good grip on the company’s financial strength and profitability.

Smart Investor Tip

You can find 10 years’ history for most listed companies by referring to the S&P Stock Reports. Some online brokerage services provide this valuable service free of charge. For example, Charles Schwab & Company (www.schwab.com) allows investors to open free accounts and offers the S&P Stock Reports and other analytical reports, all free of charge.

Technical Tests

Using a combination of fundamental and technical tests helps you to review a stock from different points of view. While the fundamentals help you to gain insights into a company’s overall financial and capital strength, technical indicators help you to judge market perception. The fundamentals look back at a company’s history to estimate the future; technical indicators are used to forecast the future based on current market information.

Price—the primary technical indicator—is the most popular measurement used by technicians. It is an easy value to find, widely reported in the financial press and online. And while the short-term price movement of a stock is not valuable as a long-term indicator, it is of utmost importance to every options trader.

Smart Investor Tip

Long-term value of stocks is inconsistent with valuation methods for options, which are by nature short-term. You need to track and monitor both.

Often overlooked in this analysis is the study of volume in a stock. You may apply volume tests to the market as a whole; they can also be applied to individual stocks. When volume increases, it indicates increased market interest in the stock. High volume can have two opposite conclusions, which will be determined by the direction that the stock’s price is moving on a particular day. You can track changes in volume and price in the financial press or on the Internet. Charting is widely available and free on many sites. The analysis of price and volume together improves your insight into the way that a stock acts in the market. You need to assess each stock based on historical price and volume patterns, as well as overall volatility in the stock’s market price.

Smart Investor Tip

Free charts of stock price and volume are available on dozens of sites, free of charge. Check these web sites for a sampling:

support level

the lowest trading price, under present conditions, below which the price of the stock is not likely to fall.

Among the things to watch for on the technical side is a stock’s support level, which is the lowest likely price level, given current conditions. On the other side of the chart is the resistance level, the highest price at which a stock is likely to trade under current conditions. The concepts of support and resistance are not only keys to the technical approach to studying stock price movement; they also are revealing because they indicate a stock’s relative volatility. The wider the range between support and resistance, the more volatile a stock; and, of course, the thinner that trading range, the more stable the stock. So a stock with a wider-than-average trading range would contain higher relative volatility. This measurement is especially instructive when comparing stocks in the same sector or with options priced at similar levels. Even when not judging relative volatility, the visualization of a stock’s trading pattern can help to identify a stock’s overall volatility over time. The level of volatility is the best method for determining a stock’s market risk.

The price range in between support and resistance price levels is called the trading range. Even when a stock’s price is moving in an upward or downward direction, the trading range may remain unchanged. For example, a particular stock might consistently trade within a 15-point trading range, although the longer-term trend is upward. When price changes occur along with significant changes in the trading range, a related change in option premium is likely to occur at the same time.

The stock price is considered stable as long as it remains within the established trading range. When the price does move beyond the trading range, that is called a breakout pattern. The essence of charting is to try to identify in advance of the breakout when it is going to occur. The chartist believes that by studying the trading patterns, it is possible to predict price movement.

The support and resistance levels as well as breakout patterns are shown in Figure 7.3. In the illustration, an initial trading range is shown at the left, with a breakout on the upside; this establishes a new trading range and is then followed with a breakout on the downside. The breakout patterns are indicated by the arrows.

resistance level

the highest trading price, under present conditions, above which the price of the stock is not likely to rise.

relative volatility

the degree of volatility in comparative form, such as between portfolios or between a specific stock and other stocks or markets.

trading range

the price range between support and resistance; the current price area where stock purchase and sale levels occur.

breakout

the movement of a stock’s price below support level or above resistance level.

FIGURE 7.3 Chart patterns.

Options traders can make good use of support and resistance and other technical theories. By observing the pattern of recent trading ranges, you may better judge a stock’s relative volatility. The chart reveals a pattern over time, so that you can judge whether the trading range is broad or thin; whether it is changing and, if so, to what degree; and how often previously established trading ranges have been modified by breakouts. The length of time a trading range remains unchanged is also revealing, as it helps options traders to determine a stock’s tendency to react to market changes in general, or to trade with its own timing pattern.

Accompanying an in-depth review of volatility, a sound analysis of a stock may include a further study of the high and low price ranges over time. This demonstrates several things. For example, the more volatile stocks—those with broader high and low ranges—may, in fact, be volatile at the beginning of the period but not at the end, or vice versa. A simple one-year summary is not reliable in terms of today’s price trend.

The stock reports in the financial press present only the 52-week high and low price ranges. Given the many possible varieties of trading patterns that can result in the same high and low summary, this information is unreliable. A more detailed study is required.

Any study in which we look at how prices have moved within a 52-week high and low range is going to be far more revealing than a more limited study of outward price levels alone. In fact, with these variations in mind, the volatility percentage is meaningless. That percentage—computed by dividing the high/low price difference by the low for the year—only provides a range distinction; it does not tell us whether a stock’s trend is up, down, or flat. It also does not demonstrate price spikes.

Example

Side-by-Side Comparisons: Five different stocks have reported 52-week trading ranges as follows:

If you were to select the least volatile stock from among this field, the first choice would be Company A. But is it the least volatile stock? A more detailed analysis shows that Company A’s price varied during the year from low of 82 to a high of 99, but in between moved up and down quite often. In comparison, Company B, Company C, and Company E all moved steadily upward during the year; their trading ranges were consistently upward-trending, whereas Company A started and ended the year at virtually the same price. Company D did the same; it began the year at $35 per share and ended at $37, but in between surged up to $55.

No single fundamental or technical test can be used reliably to identify good stock candidates. The high and low ranges might represent a fair starting point for stock selection, but the analysis should explore further into the timing and attributes of the stock and its trading range. You can evaluate stocks by tracking key indicators over time, looking not only for patterns but also for the emergence of new pricing trends. For example, you might decide to track a stock you are thinking of buying, combining dividend rate, P/E ratio, high and low range, and current price (close each day) of a stock. The worksheet in Table 7.3 can be used for this purpose. You might use the close each Friday to track a particular stock. After entering information on each line, you can begin to see how each piece of information changes or interacts with the others.

The problem with analysis is that it takes time. And the more time you spend on analysis, the more quickly it goes out of date. Having online charting services available free of charge makes your task much easier.

TABLE 7.3 Stock Evaluation Worksheet

Deciding Which Tests to Apply

How do you determine which of the many fundamental and technical tests are most useful for picking stocks, tracking them, and deciding when to sell? The answer depends on your own opinion. Before deciding on one form of analysis over another, be aware of these important points:

• Many analysts love complex formulas. A theory that is difficult to understand and that requires a lot of mathematical ability is probably useless in the real world. Avoid the complex, recognizing that useful information also tends to be straightforward and easily comprehended.

• You can perform your own tests—you do not need to pay for analysis. Even though some of the accounting-related ratios can be complex and difficult to follow, the actual tests leading to decisions to buy, hold, or sell will be very basic and straightforward. The process does not have to be complicated.

• Price has nothing to do with the fundamentals. The price of any stock reflects the market’s perception about future potential value, whereas the financial condition of that company is historical. A study of fundamentals has nothing to do with today’s price.

• The net worth of a company has nothing to do with price. Current market value is determined through auction between buyers and sellers, and not by accountants at the company’s headquarters. The actual value of the stockholders’ equity in a corporation is found in the book value of shares of stock.

• The past is not an infallible indicator. When you attempt to predict price movement through studying the fundamentals, you face an elusive task, since the fundamentals do not affect short-term price movement as much as other factors, such as perception of the market as a whole. Remember the wisdom that the stock market has no past.

book value

the actual value of a company, more accurately called book value per share; the value of a company’s capital (assets less liabilities), divided by the number of outstanding shares of stock.

• Predictions abound, but reliable predictions do not exist. You can get lucky and make an accurate prediction once in a while. Doing so with any consistency is far more difficult. You can study any number of factors, either fundamental or technical, but none will enable you to accurately predict future price movement of stocks.

• Common sense is your best tool. You are more likely to succeed if you employ common sense, backed up with study, analysis, and comparison. Market success without hard work is no more likely in the stock market than anywhere else.

• Stock prices, especially in the short term, are random. Most predictive theories acknowledge that, while long-term analysis can accurately narrow down the guesswork, short-term price movement is completely random. In the stock market, where opinion and speculation are widespread, no one can control the way that stock prices change from one day to the next.

random walk

a theory about market pricing, stating that prices of stocks cannot be predicted because price movement is entirely random.

Dow Theory

a theory that market trends are predictable based on changes in market averages.

The two major theories directing opinions about stock prices are the random walk theory and the Dow Theory. The Dow Theory contends that certain signals are confirmed independently and indicate a change in market directions. The random walk hypothesis is based on the idea that market movements are not predictable based on specific tests, and that given the presumed efficiency of the auction marketplace, there is an equal chance that future prices of stocks will rise or that they will fall. The one point that both of these theories agree upon is that short-term indicators are of no value in determining whether to buy or sell in the market. For the options investor, this is an interesting observation. If short-term price movement is unpredictable, that means that stock selection has to be done on a long-term basis. However, at the same time, you have an exceptional opportunity when using options. You know in advance how time value premium is going to change. That change occurs only due to time and is not affected by changes in the stock’s market price. So while you should select long-position stocks with the long term in mind regardless of which theory you accept about how price is determined, the method used for selling short calls will involve two elements not affected by stock valuation: option premium richness (meaning time value) and the amount of time remaining until expiration.

Even though you know in advance how time value is going to change over time, the degree of time value is affected by the stock’s volatility. More volatile stocks (higher-risk stocks) will tend to hold higher time value. So you will have greater profit potential due to higher time value in those cases, offset by higher market risk associated with owning the stock.

efficient market hypothesis

a theory stating that current stock prices reflect all information publicly known about a company.

Options traders should be especially aware of the principles underlying both the random walk and the Dow Theory, since both agree on one key point: that short-term prices cannot be accurately predicted. This idea has ramifications for options traders and, if both theories agree on that point, it probably has merit.

A third idea about market pricing supports the pricing theories expressed in the random walk and the Dow Theory. That is the efficient market hypothesis. An efficient market is one in which current prices reflect all information known to the public. Thus, prices are reasonable based upon perceptions about markets and the companies whose stock is listed publicly. If the efficient market hypothesis is correct, then all current prices are fair and reasonable. Again, this idea has ramifications for all options traders.

Anyone who has observed how the market works understands that the efficient market is a pure theory, because prices are not always applicable. For example, Value Line divides the stocks it studies into five groups, from the highest rated for safety and timeliness, down to the lowest. The first two tiers beat market averages with consistency, proving that there is value in going through the analysis of prices, price movement, and the range of fundamentals. A reasonable approach is to believe that the market is efficient, but only to a degree. Market observers know that the public tends to overreact to news in the market. Prices rise beyond a reasonable level on good news, and decline beyond a reasonable degree on bad news. So in short-term trading, prices cannot be called efficient by any means. In fact, short-term market price movement is highly chaotic and unpredictable. The often unrealistic pricing swings present momentary opportunities for you, whether operating as a speculator or as an options trader.

Like the other two theories, the efficient market hypothesis points out both danger and opportunity for options traders. Short-term price changes cannot be predicted with any reliability whatsoever, even in the efficient market; however, the characteristics of the underlying stock can be used reliably to select a profitable portfolio. It is fair to surmise that a stock with strong fundamental and technical characteristics is not only a good long-term investment, but also a viable candidate for writing covered calls. The option buyer, however, undertakes considerable risks, remembering that none of the theories place any reliability on short-term price changes. Option buyers are speculating on the short-term. Their only edge is found in the ability to locate unusual price conditions in a particular stock, and to take advantage of overbought or oversold conditions by picking and timing option purchases wisely.

Smart Investor Tip

All theories agree that short-term price changes provide no useful information. This presents problems for option buyers; for option sellers, the volatility of short-term prices can inflate time value, meaning greater opportunities for profits.

Applying Analysis to Calls—the “Greeks”

Keep the major market theories in mind when you analyze stocks, and remember that exceptionally rich option premium is not a dependable standard for stock selection. Moderate volatility in a stock’s price levels may work as a positive sign for options trading, as it demonstrates investor interest. A stock that has little or no volatility is, indeed, not a hot stock and such conditions will invariably be accompanied by very low volume, a consistently low P/E ratio and, of course, lower option premium levels. So some short-term volatility might demonstrate not only that investor interest is high, but also that option activity and pricing will be more promising as well. As a technical test of a stock’s price stability, volatility should be analyzed in terms of both short-term and long-term levels. Ideally, your stocks will contain long-term stability but relatively volatile price movement in the short term.

With the distinctions in mind between different causes and patterns of volatility, the selection of stock may be based on a comparative study of the past 12 months. First, ensure that the stocks you are considering as prospects for purchase contain approximately the same causes for their volatility. Then apply volatility as a test for identifying relative degrees of safety.

Greeks

a series of analytical tests of option risk and volatility, so called because they are named for letters of the Greek alphabet.

A series of calculations are used by options analysts to study risk and volatility in options. These are collectively referred to as the Greeks because they are named after letters in the Greek alphabet. These calculations are for the most part useful for comparative purposes in options analysis. It is good to know what they reveal, but the calculations themselves are beyond the interests of most traders. However, if you subscribe to a service that compares options for you, then it makes perfect sense to know what the Greeks reveal.

beta

a measurement of relative volatility of a stock, made by comparing the degree of price movement to that of a larger index of stock prices.

Fundamental and technical tests are complemented with the use of another feature in a stock’s price used to define volatility—that is the stock’s beta. This is a test of relative volatility, in other words, the degree to which a stock tends to move with an entire market or index of stocks. A beta of 1 tells you that a particular stock tends to rise or fall in the same degree as the market as a whole. A beta of 0 implies that price changes of the stock tend to act independently when compared to price changes in the broader market; and a beta of 2 indicates that a stock’s price tends to overreact to market trends, often by moving to a greater degree than the market as a whole.

Because time value tends to be higher than average for high-beta stocks, premium value, like the stock’s market value, is less predictable. From the call writer’s point of view, exceptionally high time value that declines rapidly is a clear advantage, but it would be shortsighted to trade only in such stocks, especially if you also want stability in your stock portfolio.

Another interesting indicator that is helpful in selecting options is called the delta. When the price of the underlying stock and the premium value of the option change exactly the same number of points, the delta is 1.00. As delta increases or decreases for an option, you are able to judge the responsiveness (volatility) of the option to the stock. This takes into consideration the distance between current market value of the stock and striking price of the call; fluctuations of time value; and changes in delta as expiration approaches. The delta provides you with the means to compare interaction between stock and option pricing for a particular stock.

delta

the degree of change in option premium in relation to changes in the underlying stock. If the call option’s degree of change exceeds the change in the underlying stock, it is called an up delta; when the change is less than in the underlying stock, it is called a down delta. The reverse terminology is applied to puts.

The calculation of delta (the delta ratio) is a study of the relationship between the stock’s price movement and value of the option. When this relationship does not move as you would expect, it indicates a change in market perception of value, probably resulting from adjustments in proximity between market price and striking price. This change is worth tracking through the delta, since it presents occasional opportunities to profit from unexpected price adjustments. The delta ratio is also called hedge ratio.

Delta measures aberrations in time value. If all delta levels were the same, then overall option price movement would be formulated strictly on time and stock price changes. Because this is not the case, we also need to use some means for comparative option volatility, apart from the volatility of the underlying stock. The inclination of a typical option is to behave predictably, tending to approach a delta of 1.00 as it goes in the money and as expiration approaches. So for every point of price movement in the underlying stock, you would expect a change in option premium very close to one point when in the money. Time value tends to not be a factor when options are deep in the money. Time value is more likely to change predictably based on time until expiration. For options further away from expiration, notably those close to the striking price, delta is going to be a more important feature. In fact, the comparison of delta between options that are otherwise the same in other attributes will indicate the option-specific risks and volatility not visible in a pure study of the stock itself. Time value can and does change for longer-term options close to the money. The delta can work as a useful device for studying such options. The relative volatility of the option is the key to identifying opportunities.

hedge ratio

alternate name for the delta, the measurement of changes in option value relative to changes in stock value.

open interest

the number of open contracts of a particular option at any given time, which can be used to measure market interest.

Accompanying these indicators of relative volatility, you may also follow open interest. This is the number of open option contracts on a particular underlying stock. For example, one stock’s current-month 40 calls had open interest last month of 22,000 contracts; today, only 500 contracts remain open. The number changes for several reasons. As the status of the call moves higher into the money, the number of open contracts tends to change as the result of closing sale transactions, rolling forward, or exercise. Sellers tend to buy out their positions as time value falls, and buyers tend to close out positions as intrinsic value rises. And as expiration approaches, fewer new contracts open. In addition to these factors, open interest changes when perceptions among buyers and sellers change for the stock. Unfortunately, the number of contracts does not tell you the reasons for the change, nor whether the change is being driven by buyers or by sellers.

Applying the Delta

The delta of a call should be 1.00 whenever it is deep in the money. As a general rule, expect the call to parallel the price movement of the stock on a point-for-point basis, especially when closer to expiration. In some instances, a call’s delta may change unexpectedly. For example, if an in-the-money call increases by 3 points but the stock’s price rises by only 2 points (a delta of 1.50), the aberration represents an increase in time value, which rarely occurs. It may be a sign that the market perceives the option to be worth more than its previous price, relative to movement in the stock. This can be caused by any number of changes in market perception. The deeper out of the money, the lower the delta will be. Figure 7.4 summarizes movement in option premium relative to the underlying stock, with corresponding delta.

FIGURE 7.4 Changes in an option’s delta.

Time value is reasonably predictable in the pattern of change, given looming expiration. It does not move in a completely predictable manner, since perceptions about the option are changing constantly.

Example

A Delta Increase: You bought 100 shares of stock at $48 per share. During yesterday’s market, the stock rose from $51 to $53, based largely on rumors of higher quarterly profits than predicted by analysts. The 60 call rose from 4 to 8, an increase of 4 points (and a delta of 2.00).

In the preceding example, market overreaction to current news presents a call selling opportunity. Distortions in value often are momentary and require fast action. The covered call writer needs to be able to move quickly when opportunities are presented.

The same strategy can be applied when you already have an open covered call position and you are thinking of closing it. For example, your call is in the money and the stock falls 2 points. At the same time, option premium falls by 3 points, for a delta of 1.50. This could be a temporary distortion, so profits can be taken immediately on the theory that the overreaction will be corrected within a short time.

The Rest of the Greeks

Beta and delta are the most popularly used and cited of the Greeks; but there are more levels of analysis as well. Another is gamma, which is a test of how rapidly delta moves upward or downward in relation to the price of the underlying stock.

gamma

a measurement of the speed of change in delta, relative to price movement in the underlying stock.

The gamma changes as the stock’s price moves away from the option’s strike price. For example, when an option moves from out of the money and goes in the money, the delta tends to increase. How quickly that occurs is where gamma comes into play. You may also consider gamma a method for measuring extrinsic value. In other words, gamma will be at its greatest level when the stock’s market value is at or near the option’s striking price. When options are deep in the money or deep out of the money, gamma will be close to zero.

For example, if a stock is at $39, a call with a striking price of 50 may have a delta of 0.50 and a gamma of 0.05. When the stock moves up to $40 per share, the delta is going to grow by the same degree as the gamma (0.50 plus 0.05, or 0.55). Because delta can only by 1.00 at the most, this trend is limited and most meaningful when market value of the stock is very close to the option’s striking price, which is always the most interesting price relationship where options are involved. Gamma is always expressed as a positive number, whether related to a call or a put; it is only a measurement of delta’s trend. The delta will change to the degree of the gamma. In the example of a gamma of 0.05, if the stock moves one point, delta will change by 0.05, or 5 percent of the stock change; so if the stock moved up two points, delta would increase by 0.10 (5 percent of two points), from 0.50 to 0.60. Delta moves by the percentage of the gamma.

You can use delta and gamma in combination to test the relationship between a stock and its options, and to select one company over another because of levels in these price-responsive trends. You will also observe that as expiration nears, the gamma for at-the-money options is going to increase rapidly. It is quite likely that gamma will grow at about trice the price movement of the stock, because the delta is responding to the combined forces of pending expiration and in-the-money or at-the-money price changes. In comparison, out-of-the-money options near expiration are going to have very low gamma trends; and as expiration is closer, the gamma trend confirms the ever-lower expectation that the option will move in the money.

Another interesting Greek is the tau, which is also termed vega by some analysts. This measures the relationship between an option’s price and changes in the underlying stock’s volatility. Whether applied to a call or a put, tau is always a positive number.

The less volatile a stock, the cheaper its options. So if and when volatility increases (especially if measured as an expansion of the stock’s trading range), option values will rise as well. Defining “volatility” as the percentage of range off a stock’s 52-week low, you can quantify vega in the same manner, on a percentage basis. This becomes very interesting because it assigns a percentage value to an option’s premium; and it also places a numerical value on a stock’s market risk. This is useful for comparisons between stocks and their options.

On average, stocks are expected to show around 15 percent volatility. For example, if a stock has traded between $20 and $23 per share, the three-point spread represents 15 percent volatility (3 ÷ 20 = 15 percent); as a stock’s value changes, vega tracks that change.

Another Greek, theta, reveals the strength or weakness of time value (exclusive of extrinsic value), also known as sensitivity of the price in relation to the time remaining until expiration. Many options traders consider theta the most important of the Greeks because time sensitivity defines value, notably near expiration.

Theta is valuable as a comparative study between two or more options (and their underlying stocks). Based on a stock’s specific volatility, time decay may be quite rapid or fairly slow; and identifying the degree of theta characteristic of a particular stock is a valuable analytical exercise.

tau

a measurement of an option’s premium value in relation to the underlying stock’s changes in volatility.

vega

a name sometimes applied to the calculation of tau.

theta

a measurement of an option’s value based on time until expiration.

sensitivity

the degree of change in an option’s value based solely on the time remaining until expiration.

rho

a calculation of the effect of interest rate trends on option valuation; a long-term analytical tool rather than one of immediate value.

The Greek rho is also a sensitivity measurement, but is far less directly involved in valuation than most other Greeks. Rho compares pricing of options to trends in interest rates, based on the theory that the higher market interest rates trend, the higher call pricing. This Greek is less useful than most others, however, because it is not easy to translate long-term trends such as interest rates, into action steps for fast-moving markets such as options. The general observation of rho is an oddity: As interest rates rise, call prices will follow, but put prices will tend to fall. In this regard, rho becomes an expression of market sentiments based on interest rates, with the results seen in option prices.

The Greeks are collectively an interesting series of observations concerning option trends and tendencies. All options traders are aware of changes in valuation based on the proximity issues: between striking price of options and market value of the underlying stock, and between today and expiration. The Greeks are useful for tracking the changes in all three forms of value (intrinsic, extrinsic, and time) but are also best used to make comparisons in option valuation between two different companies. Time, volatility, and chance all play roles in valuation; the Greeks are useful in observing how prices and values react to ever-changing market conditions.

Acting on Good Information

Example

Broker or More Broke: You bought 300 shares of stock last year as a long-term investment. You have no plans to sell and, as you hoped, the market price has been inching upward consistently. Your broker is encouraging you to write calls against your shares, pointing to the potential for additional profits as well as downside protection. Your broker also observes that if exercised, you will still earn a profit. However, remembering your reasons for buying the stock, you reject the advice. Call writing is contrary to your goal in buying the stock.

All market analysts depend on their best estimates in making decisions. You cannot time your decisions perfectly or consistently; so you have to depend on a combination of fundamental and technical indicators to provide yourself with an edge. That means you improve your percentages, but not that you will be right every time. Base your strategy on the thorough analysis and well-thought-out selection of stocks. Pick stocks on their fundamental merits as long-term investments and not merely to provide coverage for short option positions. Also keep in mind your long-term reasons for buying the stock; keep the stock in your portfolio as long as the company’s attributes remain strong. Avoid making stock-related decisions as a response to option-specific conditions. Don’t take advantage of the chance to earn a short-term profit if exercise of a covered call would contradict your long-term goals.

Even when writing covered calls is an appropriate strategy, never overlook the need for continued monitoring of the stock. By preparing a price performance chart like the one shown in Figure 7.5, you can track movement by week. A completed chart helps you to time decisions, especially for writing covered calls. If you have access to the Internet, you can also use free sites to produce price and volume charts. Three of the many sites that provide this free benefit were listed earlier in this chapter.

Track both the option and the underlying stock. If profits in one are offset by losses in the other, there is no point to a strategy except when you hedge a loss with the use of an option for insurance. By observing changes in the option and the stock, you will be able to spot opportunities and dangers as they emerge.

FIGURE 7.5 Stock performance chart.

Example

Programmed Portfolio Losses: You bought 100 shares in each of four companies last year. Within the following months, you wrote covered calls in all four. Today, three of the four have market values below your basis, even though the overall market is higher. You add up the total of call premium, dividends, and paper capital gains and losses, and realize that if you were to close out all of your positions today, you would lose money.

This example demonstrates that stocks were poorly chosen or purchases were poorly timed. While paper losses might have been greater had you not written calls, this situation also raises questions about why a particular mix of stocks was selected. A critical review of your selection criteria might reveal that you are picking stocks based on option premium value rather than on the stock’s fundamental and technical indicators. Relatively safe stocks tend to have little options appeal, because time value is minimal in low-volatility stocks. So more volatile stocks are far more likely candidates for premium action. That does not mean they are worthwhile investments; it could mean that option profits will be offset by capital losses in your portfolio.

Perhaps the greatest risk in call writing is the tendency to buy stocks that are overly volatile because they also have higher time value premium in their options. You will do better if you look for moderate volatility as a secondary strategy. Three suggestions worth remembering:

1. Select stocks with good growth potential and hold them for a while without writing options. Give the stocks a chance to appreciate. This gives you much more flexibility in picking options. The combination of premium, dividends, and capital gains can be built into your strategy with ease, assuming that current market value is higher than your original cost per share.

2. Time your decision to sell calls on stock you already own, to maximize your potential for gains from the options.

3. Remember the importance of patience. You might need to wait out a market that seems to be moving too slowly. Your patience will be rewarded if you select stocks properly. Opportunity does come around eventually, but some novice call writers give in to their impatience, anxious to write calls as soon as possible. This is a mistake.

Putting Your Rules Down on Paper

Setting goals helps you to succeed in the options market. This is equally true if you buy stocks and do not write options. By defining your personal rules, you will have a better chance for success. Define several aspects of your investment plan, including:

• Long-term goals for your entire portfolio.

• Strategies you believe will help you reach those goals.

• Percentages of your portfolio that are to be placed in each type of investment.

• Definitions of risk in its many forms, and the degree of risk you are willing to assume.

• Purchase and sale levels you are willing and able to commit.

• Guidelines for review and possible modification of your goals.

Writing down your rules leads to success because it focuses your efforts. Guidelines can and should be modified as conditions change. Having self-imposed rules to follow provides you with a programmed response to evolving situations, and improves your performance and profits.

The next chapter explains how you need to change investing strategies in volatile markets.