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Saturday, October 20, 2007

Covered Calls Selection Process

A previous article Stock Selection 101 described the Covered Calls Advisor's stock selection process. This article picks up where that article left off by describing the process used for systematically narrowing the initial list of 200-300 stock purchase candidates to a final list of 10-20 covered call positions to be added to the Covered Calls Advisor Portfolio (CCAP).

This advisor normally writes near-month covered calls on stocks whose next earnings release is sometime after the next expiration date. Since we have just completed the Oct07 expiration, we first look to eliminate from the preliminary list of 200-300 stocks, those stocks that do have an earnings release between now and Nov07 options expiration on Nov.17th. As noted in a previous post, it is desirable for the covered call writer to avoid the uncertainty along with the accompanying erratic price moves that are often associated with earnings surprises -- so we consciously avoid owning stocks when they are releasing earnings results. November is one of four expiration months (February, May, and August are the other three) when most companies will be releasing their quarterly earnings. This is true since for most companies, their fiscal year coincides with the calendar year so their quarters conclude at the end of March, June, September, and December. And since quarterly earnings are normally reported between 3 and 6 weeks after the end of a quarter, the majority of earnings releases will occur in the expiration monthly periods of Feb,May,Aug,and Nov. So, our initial screen eliminating all earnings reporting stocks from the 287 initial stock candidates identified for November expiration leaves us with only 113 remaining stock purchase candidates.

The second screen further eliminates any of the 113 stocks for which no options are traded or where the options open interest is very low(less than 150). This month that is 15 stocks, so after the options liquidity screen for November, there are now 98 (113-15) stocks remaining on the list. The third screen eliminates stocks that are, from this advisor's experience, either too volatile to be warranted as covered call investment candidates; or on the other hand too stable to generate adequate annualized return on investments -- thus equities are eliminated from further consideration that have historic volatilities below 20 or above 43. For Nov07 expirations, this volatility screen eliminates 29 additional stocks, so there remains only 69 (98-29) stock candidates for establishing covered call positions.

So now only 69 stocks remain for consideration as potential candidates for our Nov07 covered call selections. This is fewer than is normally the case; but again, that's what happens with so many earnings releases during Feb,May,Aug,and Nov expiration months. The fourth and final screen provides a list of those covered call positions (using all 69 potential stocks remaining) that meet the following criteria:
1. Common Price >$9.90
2. Open Interest >150
3. Annualized Return If Unchanged (ARIU) >25%
4. Expiration Date = 11/17/07
5. Call Option Overpriced by more than 0%
6. Stock Price between 3.5% below and 2% above strike price.
7. Historic Volatility of stock between 20% and 43%.
8. Option Bid Price >= .40
9. Downside Breakeven Protection >2.0%
The Value Line Daily Options Screener is used to conduct this screen. The 69 stock symbols were keyed and run through this screener. A total of 32 positions were identified that met all of the nine criteria listed above.

Each of these 32 positions will be entered into an 'Analysis Sheet' to identify the highest ranking covered call positions to be selected. Along with the overall rankings generated from the 'Analysis Sheets', additional consideration is given to ensure that adequate portfolio diversification as well as consistency with the overall investing 'themes' is achieved in the CCAP. The 'Analysis Sheet' includes all of the detailed factors this advisor includes in evaluating each covered call investment under consideration. A preview of these factors was provided in an earlier post 10 Factors link. Presentation of a sample 'Analysis Sheet' will be provided in a post at a later date.

Regards and Godspeed

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