So how is this necessary "discipline" applied to ensure that the essential research methods in analyzing a potential stock investment are consistently followed? The answer came from an unlikely source, a book titled "The Checklist Manifesto" (see "Link"). The author, Dr. Atul Gawande, demonstrates how ordinary checklists have been used to significantly improve complex decision-making processes in diverse disciplines such as medicine, aerospace, and yes, even in investing. The author explains how behavioral researchers have determined that there are two primary difficulties in complex decision-making:
(1) "the fallibility of human memory and attention, especially when it comes to mundane, routine matters that are easily overlooked under the strain of more pressing events"; and (2) "people can lull themselves into skipping steps even when they remember them."
To combat these difficulties, "checklists seem to provide protection against such failures. They remind us of the minimum necessary steps and make them explicit. They not only offer the possibility of verification but also instill a kind of discipline of higher performance." Checklists "catch mental flaws inherent in all of us -- flaws of memory and attention and thoroughness."
As Covered Calls investors, there are both Options and Company criteria to be analyzed before a decision to establish a Covered Calls (or Cash-Secured Puts) position in a particular company is reached. The research and analysis process for individual companies is time consuming, but fortunately the analysis of whether or not that company's Options meet the necessary criteria (by using an Options Checklist) is a quick one --it only takes about five minutes.
So first, using the Options Checklist shown below, we determine if all three necessary Options characteristics are achieved for the particular company we are interested in investigating.
I. Options Checklist
1. No earnings report prior to the options expiration date -- because of the volatility of stock prices when earnings are reported, we prefer to avoid investing in these companies when there are intervening earnings prior to the options expiration date.
2. Adequate options liquidity -- avoid options with low liquidity. Generally, a minimum of 150 open interest contracts for the strike prices we are considering is preferred. This criteria helps to ensure that a low options price bid/ask spread is available, thus minimizing slippage in our options transactions.
3. Options Implied Volatility exceeds the S&P 500 Volatility Index (VIX) -- this ensures that the potential Covered Calls return-on-investment available from the individual stock is greater than that from the S&P 500 Index.
If (and only if) all three of these criteria are successfully met, we can then proceed to the Company Checklist to evaluate whether or not that company's stock might be a worthwhile investment opportunity.
II. Company Checklist
I used to have a lengthy Company Checklist of more than a dozen items. But ultimately, I found that it was so cumbersome that I was focusing too much on the details and neglecting the big picture aspects of the company's business and its competitive position. Through further reading and researching about investing checklists, I discovered the right balance for me between the discipline of a checklist and the simplicity of a shorter, more focused list. Not surprisingly, this new checklist is the one used by renowned investors Warren Buffett and Charlie Munger. Please watch and listen to this video where they describe the four items (shown below) on their checklist process: (Link to Buffett & Munger video)
Company Checklist:
1. Fully understand the company's business
2. Quality: A good business model - has a Sustainable Competitive Advantage
3. Quality Management
4. Value -- a Margin of Safety at the current stock price
Here is the blank Company Checklist form that I currently use:
COMPANY:
____________________________ As
of: ___________
Hq: _____________________
Industry: ___________________
I. Options
Checklist
1. No earnings report prior to the options expiration date. Ex-div?
1. No earnings report prior to the options expiration date. Ex-div?
2. Adequate
options liquidity -- avoid options with low liquidity. Generally, a
minimum of 150 open interest contracts
3. Options
Implied Volatility exceeds the S&P 500 Volatility Index (VIX)
II. Company Checklist
1. Fully understand the company's business Market Cap: ________ Enterprise Value: _________
1. Fully understand the company's business Market Cap: ________ Enterprise Value: _________
2. Quality: A
good business model - has a Sustainable Competitive Advantage
Company Historic Sector
ROE
Debt/Equity N.A.
3. Quality:
Management
CEO and Vision:
4. Value: a
Margin of Safety at the current stock price
Current Price: ______ Target Price: _______
% Change: ______ Reuters: _________________
Company Historic
Sector Piotroski: ____
P/CF
P/BV
P/S SUMMARY COMMENTS:
5. Growth:
Future Earnings, Revenue, and P/E Potential
EPS: LY ______
Rev: LY ______ P/E:
TY ______ TY
______ TY ______
FYF ______ FYF ______ FYF ______
Historic ______
This approach of consistently applying the Options Checklist followed by the Company Checklist provides the discipline necessary to reduce our stock selection mistakes and therefore to improve our overall return-on-investment results.
I hope you will consider applying this Options Checklist and Company Checklist in your own Covered Calls investing process. As always, email me at partlow@cox.net with your comments or questions regarding anything in this article or anything else related to Covered Calls investing. I welcome your feedback.
Best Wishes and Godspeed,
Jeff
