What Investments Should I Buy for Options Trading?
“Do you have a method or strategy to choose the underlaying security for covered call options? I would appreciate your insight on how to choose and buy underlaying security if not holding anything yet!” This question is from one of my readers. It is an excellent question. I have written several posts about things to look for when buying an investment, whether it is a stock or an ETF. Some of the same rules apply for buying investments for trading covered call options.
When Baking Do Not Use Rancid Ingredients
When you are making a pie, you want fresh ingredients. Rancid apples don’t make for a good pie. What does a bad apple look like? If the apple has soft spots or some nasty bruising, it might be a bad apple. If it has holes, and worms in the holes, consider it bad. If the apple is mushy and not crisp, then you are probably holding an apple that should go into your garden mulch.
The same type of analysis should be conducted when picking the apples for your portfolio. You want solid, quality investment apples. You want an investment to have some shelf life. You want investment apples others also want to buy, driving up the price of the investment as a part of supply and demand.
Stock Picking Guidelines for Covered Call Options Novices
I will start with five guidelines for newbies in the world of stock options trading. But just because I say “newbie” doesn’t mean I don’t do the same. What is fundamentally sound for a beginner is usually fundamentally sensible for the more experienced investor.
Number One is Dividends
The first of the five is the overall strategy to focus on dividend growth investments. If the stock market struggles, you should not feel compelled to trade options. The last two years have been painful for “growth” investors. My pain, if I would even call it that, was like stepping on a Lego, not on a scorpion. You see, I can afford to continue to collect the dividends and wait for another day to trade options. Options, in reality, are also optional income. I want the steady income from dividends and I delight in the extra “synthetic dividends” or “rental income” I receive from covered call option trades.
Number Two is Seek Value
While it is true that the price of a stock is of minimal importance to me, I always strive to buy quality. In other words, I want value for my dollar. This means I like buying shares of AVGO at $575 per share and I also like buying shares of PFE at $45 per share. The per share price isn’t material. Think of it this way. I like blue jeans. If I can pick between two different pairs of jeans of the same fabric and construction quality, and one pair is $30 and one is $75 dollars, I will buy the $30 jeans. Price is not, I repeat, is not the main thing. Quality and value are what I look for in an investment.
However, if your portfolio is less than $250,000, buying 100 shares of AVGO at $575 per share would mean you would have an investment of $57,500. That would mean you would have more than 20% of your assets invested in a single company’s stock. As much as I like AVGO as an investment, that would be a foolhardy approach for a new investor with limited total assets. I think 5% should be an upper limit for most investors.
Therefore, it is best to start with some lower cost investments where your total investment is less than $10,000, or slightly more, if you have $250K in assets in your investment account. This, of course, can vary based on the total value of your investments, When I suggest $10K, this would not be more than 5% of your total investment portfolio. What can you buy for $10,000? You could buy shares of Ford (F), Pfizer (PFE) or Verizon (VZ). These are not recommendations. These are just examples of stocks where you could buy 100 shares and not risk a huge loss. PFE and VZ are probably lower risk investments, but it is likely you can earn more from them trading covered calls as well.
Number Three is Sensible Diversification
Let’s suppose you have $30K to invest in some stocks for covered call options trading. Don’t put the entire $30K into a single stock. Think about diversification. Are the stocks you are adding improving your overall diversification? One of the reasons I suggested F, PFE, and VZ is that each of them is in a different business sector. Pfizer is in the health care sector, Ford is a consumer discretionary company, and Verizon is a communications services business.
Look at your total portfolio. Fidelity has tools on their website to help you do this with just a few clicks. If you have mostly ETFs or low-cost mutual funds, you are probably sufficiently diversified. If you have invested more in individual stocks, then verify you won’t be overweighting a sector that may face pain in a recession – unless you have a dividend-growth focus and purposefully overweight some sectors (like I often do.)
Number Four is Opportunity Frequency
Consider focusing on stocks that have weekly options. This gives you more opportunities to sell covered calls with shorter contract durations. If you decide to use a monthly options position, determine if you are willing to hold the position for the long-term and not panic sell. Does it meet your particular investment buy requirements? When you are learning to trade options, the goal is to make some money, but not a boatload of money. Think small and aim low. As you gain experience and confidence you can become slightly more adventuresome.
There are advantages to stocks that only have monthly options. By taking a longer risk of 3-4 weeks, you can also earn more than you might earn for a weekly option trade. My three examples (F, PFE, and VZ) all trade weekly options. While I don’t own shares of VZ, we have a significant investment in both Ford and Pfizer.
Some of you may be thinking, “Couldn’t I make more trading four weekly options than one monthly option?” Good question. The answer is maybe. The biggest advantage is greater flexibility with weekly options. So if I could do four weekly options trades, earning $25 for each trade or $100 for a monthly option, which would I choose? My answer is “it depends.” When is the next Ex-dividend date? When is the next earnings date? Weekly options give you more control as those dates approach.
Number Five is Ratings Matter
In general, the advice you receive for investments to buy should come from a credible source. This includes both dividend growth investments and investments that don’t pay a dividend. For example, I own 400 shares of TITN (Titan Machinery.) I purchased 200 shares in March 2022, 100 more shares on April 11, 2022 and then the last 100 shares on April 12, 2022. The shares I purchased in April cost far less than the March shares. TITN does not pay a dividend. It is a growth investment.
What was important to me about TITN were the ratings. The Fidelity Equity Summary Score is 7.6 “Bullish.” Titan’s QUANT rating on Seeking Alpha is a very strong 4.96 “Strong Buy.” It doesn’t get much better than that. On StockRover, I look at the scores for Value, Growth, and Quality. The valuation score is 89, the growth score is 94, and the quality score is 77.
On StockRover it is also helpful to understand the Piotroski F Score and the Altman Z‑Score. According to SR, the “Piotroski score determines the financial strength of a company based on 9 criteria. Companies with a score of 8 or 9 are considered strong. Scores between 0 and 2 indicate a weak company.” The Altman Z‑Score is a “popular credit-strength measure aims to show how likely a company is to go bankrupt. Risky companies have a score below 1.8. Solid companies have a score of 3.0 or higher. Financial institutions like banks are not scored.”
If you only have the funds to buy one subscription, then I suggest you start with Seeking Alpha. The QUANT rating is an excellent way to avoid rancid investments.
Speculation and Investments to Avoid
Speculation is reasoning based on inconclusive evidence, wishful thinking, conjecture or supposition. So a speculative investment is one that someone might buy as a long-term investment because of a thesis (theory or notion) that the investment could be valuable in the future. It is generally based on a thesis that’s not currently verifiable by data or past history.
Therefore, speculation involves taking a chance on an investment based on limited facts. It’s a high-risk investment with a huge potential for loss or complete failure. Therefore, it is like buying a Wisconsin lottery ticket which has a high-reward for a very small number of people. It is a gamble for those with a strong appetite for risk.
Three Tips: When to Buy Shares
The best time to buy more shares is, in my opinion, when one of the following opportunities arises: 1) When the stock market has a down day. If the market is down by 1.0% or more, I start shopping around. 2) When one of my holdings has a dramatically down day. If something I like is down by 2-5%, then I look for the reason(s). If it is general panic based on some short-term news, I consider buying more. One way to see this is to look at a tool that Fidelity provides. It shows the top three and bottom three MOVING investments in any account (or all accounts) at any point in time. 3) When a dividend increase is anticipated. If a company increases their dividend annually, then buying shares before the anticipated announcement date can be opportunistic. This is not hard to determine. The information about when and how much the historical dividend increase can been found on Fidelity Investments, Seeking Alpha, and StockRover. I like the graphs that SA and SR provide.
Pay Attention to the Clock
There are times of day when it is probably best to avoid buying shares. Unless you are an advanced trader, you probably should not buy shares during the first 30 minutes the markets are open. Generally, it is also best to avoid the last 30 minutes. Because I can do pre-market and post-market close trades, I always think twice about the early and late trades of the day. Traders get crazy during the pre-market and early market trading. Don’t join them in their craziness unless you see an incredible bargain.
Add shares slowly but methodically
Pause and think for just a moment. You need cash available to buy more of what you already own or to buy a new investment. If you have $10,000 to invest, rarely should you want to invest all of the dollars today. The idea is that you might be buying PFE at a good price at $48, but next week the price might be $47. If I buy 10 shares this week at $48 and 20 shares at $47 the next week, my average cost for the 30 shares is less than $48 per share. A lower cost basis means you are buying a higher dividend yield and the potential for more capital appreciation.
Averaging Up in a Bull Market
Averaging up is the concept of adding to a position you own that has risen in value. When you do this, you are driving up the average cost of your position by accumulating shares at a price that is higher than your previous purchase. You and I are hardwired to avoid averaging up. We dislike buying something today that we could have purchased yesterday for less money. If I had originally purchased PFE for $35 per share (my average cost in my IRA for PFE is $34.45 per share), then I don’t see $48 as a bargain. That is faulty logic. What if the price of PFE shares is $56 a year from today? If that happens, then buying at $48 would be brilliant. That would be a gain of over 16.7%. And, because PFE pays dividends, the actual benefit is even greater.
Summary
The goal of this post was to answer the question at the beginning of this post: “Do you have a method or strategy to choose the underlaying security for covered call options?” The primary strategy is to buy dividend growth investments that are a value at the current market price and that have solid quality indicators on Seeking Alpha and StockRover. The subscription to either of these can save you from making a lot of mistakes.
Links for Learning
Wise investors understand the power of Dollar Cost Averaging. INVESTOPEDIA LINK
Know Your Flocks & Herds 