Tuesday, November 21, 2006

Trade Selection

For stock selection, I basically use the methods described in Pat Dorsey's book "The Five Rules for Successful Stock Investing: Morningstar's Guide to Building Wealth and Winning in the Market". Mr. Dorsey is the Director of Stock Analysis at Morningstar. This is a value investing approach. I look for companies that generate positive earnings, free cash flow, have good return on equity and low debt. I use Morningstar to find these companies and then run the stocks through Value Line Daily Options Survey (I previously used PowerOptions) to find potential covered call trades.

Here is an example of the thought process I go through when selecting and analyzing trades.

This is an excerpt from a Yahoo discussion regarding a proposed WFMI trade on 11/2, where the stock dropped about 23% the following day after an earnings announcement.

First of all, establishing a covered call trade on or near the day of earnings announcement is risky. It's better to wait until after the announcement to see how the stock reacts.

With that said, let's assume that a position was established on 11/2 using closing prices of that day per OptionsXpress Historical Quotes:

Buy 100 WMFI at $60.13
Sell 1 Dec06 50 Call at $11.59

Stock Investment: $6,013.00
Income Generated: $1,159.00
Percent Income Generated: 19.27%
Net Profit If Called: $146.00
Percent Return If Called: 2.43%
Annualized Return If Called: 20.61%
Days to Expiration: 43 days

The stock dropped $13.86 (23.10%) to $46.26. The break even is $48.54 so the above position is only down $2.28 (3.8%). And there's still 43 days until expiration, so the stock could recover back up to $50 and get called away for the expected profit.

This is just an example and not necessarily what I would have done, but it just shows that it was possible to put on this trade and still make out ok.

Here's how I would have analyzed this trade.

First I start with the company. WFMI is a good solid company. They've had increasing sales revenue and earnings per share for the past 10 years. They've generated free cash flow for the past 5 years. Their return on equity has averaged about 14% per year over the past 10 years. They have a very low debt/equity ratio. And they pay a dividend, which currently yields 1.3%. So, in my view this is a good stock to own for the long term.

Then I read the Morningstar analyst report and compare the stock price relative to the fair value. I try to find companies that are trading at a discount to their fair value. If a stock is overpriced I usually skip it. In this case this stock was undervalued according to Morningstar.

Next I would see if the cost of the stock is within my position sizing limit, which is 5% or less of total capital. So, for example, if I had $100,000 total capital, that limit would be $5,000 per stock position. In this case the total stock cost, including commissions, is $6,013, which is over the limit so I probably would not have placed this trade.

If the stock is within my position sizing limit, I would then look at the options to see if I could place a covered call trade that meets my return and downside protection criteria. For this example I used SysCW's criteria of 15%/15%.

If the trade has passed all of the above I then look at news and company events. I probably would not have placed this trade on this particular day since earnings were going to be announced after the market close. I would have waited a few days to see how the stock reacted.

Now, let's assume I ignored some of my rules and established this position anyway on 11/2. The stock is down about 23%, trading at $46.26, which is below the strike price of $50 with 43 days until expiration.

Now, since I've already determined that WFMI is a good long term stock, I would not close the position and take my loss. I would hold out until expiration. If the stock recovers and closes above $50 I would make my expected return. If not, I would sell another call at that time and may dollar cost average to pick up more shares at a better price.

Update as of 11/21: WFMI is trading at $49, within $1 of the strike price with 24 days before expiration, so it looks like this trade just might work out.

The key is in the stock selection. I only choose stocks I'm willing to buy & hold, so when they drop I don't panic and sell at a loss. These are potential long term holdings. If I'm not willing to hold a stock I don't buy it.

In my opinion, the following 5 assumptions, as described in Options Trading for the Conservative Investor: Increasing Profits Without Increasing Your Risk (Financial Times Prentice Hall Books) by Michael Thomsett, are critical to successful covered call trading.

1. You will limit option activities to stocks you have pre-qualified.

2. You believe that your stocks will rise in value.

3. You accept the premise that fundamental analysis of stocks is an
essential first step in the process of examining options opportunities.

4. In the event of a temporary downward movement in a stock's price, you
would be happy to buy more.

5. You believe that there are an adequate number of available stocks that
meet your criteria.