Search This Blog

Tuesday, September 25, 2007

Ten Factors to Consider when Analyzing a Potential Covered Call Investment

Too often we are prone to ask just two questions when we are analyzing a potential covered call (cc) position, namely:
1. Does it meet my minimum 'annualized return-on-investment %' threshold?
2. Does it provide adequate 'downside breakeven % protection'?

These questions are excellent to ask, but they should not be the sole factors considered when deciding whether or not to establish a particular covered call position.

For this advisor, the desired thresholds for these two factors are:
(1) >30% annualized return if the stock price is unchanged (ARIU) from its original purchase price; and
(2) >2.5% breakeven downside protection for near-month covered call positions.
Your own personal thresholds will likely differ from these, and that is fine; each investor will have his/her own risk tolerance level. Some investors are comfortable investing to achieve a somewhat lower return rate in order to obtain greater safety; while others seek higher returns and are willing to accept greater risk. That's all well and good. But regardless of your own personal risk/reward profile, it is essential that you consciously decide what your own risk level is; then, and only then, you should establish your personal thresholds for these two primary measures.

If we could only use two factors when analyzing potential covered call positions for investment, the two mentioned above would definitely be the ones to select. Fortunately however, there is no law that requires a limit of only two. These two should really serve only as the starting point in a total analysis of which specific covered call positions are worthy of a commitment of funds. Once it is determined that a particular cc option position meets the two basic thresholds, then this advisor suggests using eight additional factors to evaluate the relative value of a particular cc investment.

The eight additional factors considered by this covered calls advisor include:
1. Safety -- Downside protection is certainly one measure of safety, but there are others to consider. They include: days until expiration; days until next earnings release; the stock's historic volatility; dividend yield; financial liquidity as measured by the 'current ratio'; and financial leverage as measured by the 'debt/equity ratio'.
2. Profitability -- Two measures are determined here: free cash flow return on invested capital; and return on equity.
3. Stock Advisory Service's Ratings -- What is the overall rating of the company from the viewpoint of the two stock advisory services whose stock selection advice you prefer?
4. Value -- After the two primary factors (annualized ROI and breakeven downside protection), a particular company's valuation characteristics is the next most highly-weighted factor in this advisor's evaluation process. The measures used here include: volatility ratio (option's implied volatility divided by the stock's historic volatility); industry rating; price/earnings ratio; price/cash flow ratio; return on equity trend; and price/sales ratio.
5. Growth -- Three measures are used: price/earnings future growth rate; sustainable growth rate; and year-over-year cash flow per share growth.
6. Momentum -- Based on three measures of: stock price momentum; analysts' earnings estimates changes; and earnings surprises.
7. Management -- Currently uses the 'corporate governance quotients' both in comparison with its own industry and in comparison with all other companies.
8. Options Liquidity -- To ensure that there is adequate options liquidity to transact the option trades at a fair price. The option's 'open interest' as well as the bid/asked spreads are considered here.

Upon first reading, it is likely that these ten factors and all their related sub-factors will seem somewhat overwhelming. Well they are, at least for now. But over time, in-depth explanations of each of these items will be provided here. And as we are able to explore each of these factors more fully, their usefulness as an important part of developing and managing your own successful covered calls investing program will be demonstrated.
Looking forward to this journey with you.

Regards and Godspeed

2 comments:

  1. This is a nice comprehensive list. Thanks for explaining all of the factors in such an easy format!

    Would you say that you ranked the factors in order of importance?

    Thanks!
    -Bekki

    ReplyDelete
  2. Thanks for the compliment Bekki. If I had ranked them in order of importance they would be: ROI, downside protection, value, safety, growth, profitability, advisory services' ratings, momentum, management, and options liquidity.
    Jeff

    ReplyDelete