A lot of emphasis is placed on selection of one strategy over another. Are you conservative or a speculator? Are you trying to make fast money or hedging equity positions? In fact, this is a primary concern among traders. The strategy should match the risk profile, of course. But there is much more to how and why you trade options.
Once you decide on a favorite strategy or group of strategies, which underlying do you pick? Very little is said about this among traders, and it appears that many have a few favorite stocks they use for options trading. This can be based on many factors, including past experience and levels of success. Many options traders focus on positions like covered calls and limit their trades to positions held in their portfolios. This ultra-conservative approach makes sense but easily overlooks the flexibility of other strategies with similar risk profiles, such as uncovered puts. The risks are the same, but the uncovered put is far more flexible because owning equity positions is not part of the strategy.
However, if you are one of those traders focused only on the strategy, how do you pick the underlying? One method is preferable over all others: Dividend yield and history.
This is true even if you do not own stock. Clearly, a higher dividend yield is preferable over an underlying with a low-yielding dividend or that pays no dividend at all. But beyond this, it may also make sense to pick high-yielding dividend stocks and to also focus on dividend achievers, those companies increasing their dividend per share every year for at least the last 10 years. Why is this?
Although there are exceptions, dividend achievers tend to exhibit out-performance by the share price compared to the rest of the market. These also tend to show lower volatility and to provide strength in both fundamental and technical indicators. Dividend achievers provide greater benefits than dividend per share. That measure may itself be deceptive if the growth is minimal compared to increases in net earnings. Based on the payout ratio, a dividend achiever might not keep pace with profitability. For this reason, options traders will make the best selection of underlying issues when they look at all three dividend indicators:
- Dividend yield
- Payout ratio
- Dividend achiever status
There is also a fourth test worth applying. The debt-to-capitalization ratio is crucial to judging dividends and picking underlyings to trade options. Capitalization represents the sources of capital, namely long-term debt and shareholders’ equity. As the ratio grows over the years, more and more of future profits will have to be used for debt service, meaning less profits will be left to pay dividends. A strong, well managed company will report consistent or declining debt-to-cap ratios. When the ratio rises, it is a danger signal, demonstrating that management is not controlling working capital effectively.
Many people do not see the relationship between long-term debt and dividends. But imagine this scenario: Profits are flat or even falling, but the dividend per share is increased. How is this even possible?
It could mean that the company is allowing long-term debt to increase. That extra money borrowed is used to pay a higher dividend. Whenever profits are flat, but dividends rise, look at the debt-to-cap ratio. If it is going up each year, the positive-looking dividend history is a false signal. Eventually the company will have to pay for its over-reliance on debt. If you’re not sure about this, look back at the history of Eastman Kodak, General Motors or Sears. They all fell into the trap of letting long-term debt run away and move above 100 percent of total equity (meaning equity value was less than zero). For options trading, it might still be possible to make a profit in the short term, but over time it tends to go downhill along with the stock price.
Options trading relies on both technical indicators and fundamental trends, despite a popular belief that you can learn all you need from implied volatility and pricing models. Nothing could be so deceiving as this belief, and on the popularity of signals that reveal only part of the larger picture. Options trading is not so far rem oved from stock analysis and corporate strength (or weakness) that you can ignore it completely.
The broader your sources of information, the better your track record will be in trading options. There are few if any indicators that can be used on their own and without looking at related signals and trends. Picking the underlying is not just a matter of richer than average options as the means for selection. Turning to the three dividend signals plus trends in long-term debt and total capitalization, give out a complete picture of what is taking place, and this leads to more informed decisions.
Too many traders shun fundamental analysis when picking underlying issues for options trading. But this is invariably a mistake. More information leads to better decisions.
Michael C. Thomsett is a widely published author with over 80 business and investing books, including the best-selling Getting Started in Options, coming out in its 10th edition later this year. He also wrote the recently released The Mathematics of Options. Thomsett is a frequent speaker at trade shows and blogs on his website
What Is SteadyOptions?
Full Trading Plan
Complete Portfolio Approach
Diversified Options Strategies
Exclusive Community Forum
Steady And Consistent Gains
High Quality Education
Risk Management, Portfolio Size
Performance based on real fills
Non-directional Options Strategies
10-15 trade Ideas Per Month
Targets 5-7% Monthly Net Return
Recent Articles
Articles
Pricing Models and Volatility Problems
Most traders are aware of the volatility-related problem with the best-known option pricing model, Black-Scholes. The assumption under this model is that volatility remains constant over the entire remaining life of the option.
By Michael C. Thomsett, August 16
- Added byMichael C. Thomsett
- August 16
Option Arbitrage Risks
Options traders dealing in arbitrage might not appreciate the forms of risk they face. The typical arbitrage position is found in synthetic long or short stock. In these positions, the combined options act exactly like the underlying. This creates the arbitrage.
By Michael C. Thomsett, August 7
- Added byMichael C. Thomsett
- August 7
Why Haven't You Started Investing Yet?
You are probably aware that investment opportunities are great for building wealth. Whether you opt for stocks and shares, precious metals, forex trading, or something else besides, you could afford yourself financial freedom. But if you haven't dipped your toes into the world of investing yet, we have to ask ourselves why.
By Kim, August 7
- Added byKim
- August 7
Historical Drawdowns for Global Equity Portfolios
Globally diversified equity portfolios typically hold thousands of stocks across dozens of countries. This degree of diversification minimizes the risk of a single company, country, or sector. Because of this diversification, investors should be cautious about confusing temporary declines with permanent loss of capital like with single stocks.
By Jesse, August 6
- Added byJesse
- August 6
Types of Volatility
Are most options traders aware of five different types of volatility? Probably not. Most only deal with two types, historical and implied. All five types (historical, implied, future, forecast and seasonal), deserve some explanation and study.
By Michael C. Thomsett, August 1
- Added byMichael C. Thomsett
- August 1
The Performance Gap Between Large Growth and Small Value Stocks
Academic research suggests there are differences in expected returns among stocks over the long-term. Small companies with low fundamental valuations (Small Cap Value) have higher expected returns than big companies with high valuations (Large Cap Growth).
By Jesse, July 21
- Added byJesse
- July 21
How New Traders Can Use Trade Psychology To Succeed
People have been trying to figure out just what makes humans tick for hundreds of years. In some respects, we’ve come a long way, in others, we’ve barely scratched the surface. Like it or not, many industries take advantage of this knowledge to influence our behaviour and buying patterns.
- Added byKim
- July 21
A Reliable Reversal Signal
Options traders struggle constantly with the quest for reliable
By Michael C. Thomsett, July 20
- Added byMichael C. Thomsett
- July 20
Premium at Risk
Should options traders consider “premium at risk” when entering strategies? Most traders focus on calculated maximum profit or loss and breakeven price levels. But inefficiencies in option behavior, especially when close to expiration, make these basic calculations limited in value, and at times misleading.
By Michael C. Thomsett, July 13
- Added byMichael C. Thomsett
- July 13
Diversified Leveraged Anchor Performance
In our continued efforts to improve the Anchor strategy, in April of this year we began tracking a Diversified Leveraged Anchor strategy, under the theory that, over time, a diversified portfolio performs better than an undiversified portfolio in numerous metrics. Not only does overall performance tend to increase, but volatility and drawdowns tend to decrease:
Sunday, February 16, 2020