How To Use Fundamental Analysis To Pick Stocks

Now that we know the risk factors that cause losses in covered call positions (later we will look at the investor’s own actions that cause losses), it is necessary to survey the fundamental and technical factors that are important in covered call writing.

Fundamentals

Once a population of high-returning covered call trades has been obtained, the conservative writer begins with the fundamentals. To repeat: those who write based only upon the return offered and who do not evaluate the fundamentals are not in the game very long. Fundamental analysis can be far more detailed than the elements presented here, but the goal is not to play stock analyst. The goal is to assure ourselves of the stock’s worthiness and to look for danger signs.

The following analytical process can be used for this: if a stock does not make the cut, I want to find it out quickly in order to waste as little time on it as possible. For this reason, the most important (deal-breaker) elements are viewed first.

Average Daily Volume

Volume is, very generally, a measure of the stock’s liquidity and stability, though not necessarily of its essential soundness. Low-volume (which means smaller) stocks can provide good returns, but they are subject to manipulation and can easily be moved; they are not conservative writes. There are too many great trades with strong volume to justify writing the low-volume stocks. Even if you are looking for more volatile stocks for trading opportunities, choose high volume. The average daily volume is what matters. Note that volume is just one metric; a low-quality or highly volatile stock can trade enormous volumes. At one time, Taser Int’l (TASR) traded an average daily volume of 50 million shares a day in the $30’s. This high volume, though, certainly did not make it a conservative covered call stock.

Preferred: 1,000,000 shares daily; all things being equal, more is better.

Earnings and the Price-to-Earnings (P/E) Ratio

The P/E ratio is hardly perfect and tells us nothing about the quality of earnings, or whether earnings are growing or declining. But it nonetheless serves as a useful metric to compare stocks in the same industry. A P/E ratio significantly higher than the industry average results because the market really likes the stock; but that faddishness can change, and in an eye blink. If market sentiment changes (ex: bad earnings report), the stock can sell off. The more overvalued it is, the greater the sell-off.

Earnings matter a great deal in covered writing. Stocks with no earnings (or heaven help us, no revenues) can only trade based upon an estimated forward P/E, which may never materialize. In a correction or bear market, stocks with no earnings or an abnormally high P/E ratio get hurt first and stay down the longest. The only permissible exception is the large, household name company that remains robust but temporarily has lost its way. I used to write Xerox (XRX) years ago when it was $10 and had lost its way, but offered great premium regularly. But the “blue chip” exception aside, companies not making money simply are not conservative writes.

• You must first know the average P/E for the company’s industry.
• The more conservative stocks have a P/E that is less than twice the industry average.
• If the industry P/E itself is quite high – over 50 – then at some point the industry will sell off when one or two bellwether companies falter. For example, how many times have we seen the semi-conductor industry sell off heavily on a warning form Intel? This is not a primary danger signal, but it is well to pay attention to it. In fact, watch for news and analysis of the industry for early warning.

Earnings Growth and Quality

There are earnings, and earnings. Many events impact earnings, including one-time, extraordinary events that are irrelevant to earnings quality. By quality, we refer to operational earnings (and cash flow), not extraordinary events, such as the sale of a division or one-time write-off. And it is a fact that companies, which live and die by earnings reports, manage their financial results in order to show more earnings. Sometimes the earnings presented are misleading. Unfortunately, earnings quality is difficult to assess without a detailed examination of financial statements. For this reason you may wish to focus on earnings growth and reliability, since reliable earnings growth is a quite usable metric.

Earnings growth, quarter over quarter, is an important indicator for the value and stability of the company. Well-managed companies make money, and lots of it; and they keep increasing earnings. Even in a faltering economy, they will be the brighter lights. They are a lodestone for conservative covered call writers and buy-and-hold investors alike. The five-year growth rate also is helpful, since strong growth over this period coupled with quarter-on-quarter growth shows strength. For mid-cap and smaller companies, earnings growth is far more important than for large-caps, from the standpoint of covered call risk. You may wish to avoid stocks with a P/E over 60 for covered calls unless creating a Collar Trade position.

I focus least of all upon earnings per share (EPS), since this depends on the number of shares outstanding. A stock buyback would inflate EPS without a corresponding earnings increase. And issuing new shares (e.g., public offering, merger) would decrease EPS but the cash inflow might be quite positive.

Other Price Ratios

Conservative writers prefer companies whose Price to Sales (P/S) and Price to Cash Flow (PCF) ratios are not significantly higher than the industry averages. Cash flow in particular measures the company’s operational health. These metrics are highly regarded by stock analysts as indicators of valuation fairness. Book value and the Price to Book Value ratio are not very useful in gauging share value, simply because the market is looking for cash flow. Everything comes back to cash flow. 

Open Interest (OI)

Open interest is the number of contracts of a particular option series that is outstanding and it is a measure of the option’s liquidity. The smaller the OI, the less liquid is the call. Also, illiquid calls usually involve a large spread between the call’s bid and asked prices, which picks our pockets on both trade entry and exit. OI under 1,000 indicates very low liquidity.

• OI ideally should be at least 2,500, and higher is better.
• Conservative: high OI and high stock volume, all else being equal.
• Quite Risky: low OI, low stock volume.

Industry

The industry in which the company operates should be looked at for its health, valuation fairness (P/E and other price-multiples) and performance (trend). If the industry is trending down, then the stock must be that much stronger in order to merit being written. Some d0n’t believe this to be important, but a stock in a strong industry is more likely to perform well, all things being equal; and vice-versa. If the industry is selling off, the stock will almost always falter.

Volatility and Implied Volatility (IV)

Volatility tells us how volatile the stock, such as Amazon, has been, usually over the 10-, 20- and 30-day periods, although only a reading of the chart allows actual interpretation of the volatility number. Volatility may be flat compared to earlier periods, increasing or decreasing. IV indicates whether option prices are implying a potential future volatility that is lower than, in line with or higher than historical volatility.

I first compare the current 30-day volatility to the prior 30-day period, to see if volatility is increasing. Then I look at the 10-day volatility to see if there is a very recent increase. I am most concerned about the current 30-day level, but spiking 10-day volatility sends me checking for whatever is driving it. Under 20% volatility is low, but such stocks do not usually offer much premium return. Keep in mind that the markets usually exhibit an overall volatility of less than 15%. From 20-40% is a medium level of volatility, and over 40% could be considered high. Over 80% is sky-high. These are my personal views, based on long experience. I am less inclined to worry about volatilities in the 40-60% range when the stock is a large-cap. Only you can decide what volatility level you are willing to confront, but sticking with large-cap and the larger mid-cap companies in the 25-50% range can yield good returns on your writing.

Implied volatility should be measured against the 10-day volatility, since options should price in the most current stock movement. If IV is in line with the lower 30-day volatility instead of the higher 10-day volatility, then the more recent volatility simply is not being priced into the option; the market is not concerned about it. We will examine IV more closely below in the News discussion.

In addition, stocks might not be particularly volatile but carry a high backdrop of IV (volatility expectations), such as overhanging pension problems, or such. This is one advantage of consulting fixed covered call lists: by regularly seeing what is on the lists, it is easier to triangulate high-returning stocks with their volatility and implied volatility numbers.

• Look for volatilities in the 25-50% range, but we can be more forgiving of larger companies.
• If recent volatility is increasing meaningfully, it is prudent to ascertain what event is moving the stock. Even if IV is not keeping pace with the recent volatility surge, you still should know what is driving the price action.
• When IV has spiked above historical volatility, we are warned that a news event is pending.

Fundamental Rank

Sometimes it is helpful to consult a fundamental ranking of overall quality. The MSN StockScouter ranking provides such a metric, which is a blend of technical and fundamental factors, ranking companies on a 1 to 10 scale (10 being the best). MSN also explains in detail the reasons for the ranking. There are similar rankings available from other sources, as well.

Insider Transactions

Insiders (officers, directors and major shareholders) are required by law to file reports when they buy or sell securities of their company. These reports are widely held to indicate whether the insiders consider their company’s stock a buy or a short. This view is premised on historical observations that insiders tend to buy their company’s stock when the outlook is bright and sell ahead of bad times for the company. This makes sense, because they have the ultimate informational advantage.

However, insider transactions are a difficult metric to use. First, insiders tend to sell heavily when the company reaches new highs; or old highs, for that matter. Wouldn’t you? Second, because so many companies have fat option plans and “reload” provisions, only market buys are a real indicator of insider optimism – yet one has to read the Form 4 reports to sort out the market buys from other buys.

Insider selling is more significant when the stock is declining or when the company’s prospects are in decline, since it suggests rats leaving the ship. These are the circumstances in which the information is most useful and the only time I use it. It is more of harbinger of bad things to come, and may not represent an immediate threat.

News Events

Amazingly, to me, most covered call experts don’t say much, or say nothing at all, about checking for news events on a stock with high premium. Is it important? The answer is: sometimes. Recall from earlier discussions of implied volatility that the higher the level of time value premium, the more volatility is being implied. When IV is significantly higher than actual volatility, there is then reason to check to see what news event is driving premium so high.

This is all the more true if actual volatility recently also has been increasing and IV is significantly higher than the 10-day volatility. For this purpose I use the 10/10 rule, meaning that there is cause to look for news if IV exceeds actual volatility by more than

• 10 percentage points, or
• 15%, whichever is greater

Thus if the stock’s volatility is 40%, I would ignore IV that is merely 15% higher (46%) but would look for news if IV was 50% (ten percentage points higher), or more. Feel free to adapt this rule based upon your own experience with it. There is a certain amount of “noise” in the pricing system, and IV will never be exactly the same as the stock volatility. Sometimes IV is no higher than historical volatility, or even is lower, despite pending news. In such cases, I conjecture that the in-line or low IV means the market has discounted the news.

Recall that IV prices in the market’s expectations of the stock’s future volatility and that stocks appear on lists of high covered call returns because either IV or actual volatility are high. While a spike in IV does not mean the stock’s volatility will increase on news, it does mandate that the careful call writer find and evaluate the news.

It takes proportionally more significant news to move a large-cap stock than a smaller one. When the stock is one of low volatility, it takes a more serious event to move it because it just doesn’t move much, and an IV spike is all the more significant. For a stock with a normal 20% volatility, IV of 30% is high and 40% is quite high, for example. If the stock has already risen on pending news, IV often will spike due to market concerns that the stock will sell off on good news or bad. An IV increase of 10 percentage points on a high-volatility stock (ex: 80%), on the other hand, is less meaningful. I pay more attention to an IV spike if the company is a tech or pharmaceutical. But to repeat: IV that is really spiking should not be ignored, no matter the business or size of the company.

To check for news, the headlines can be scanned quickly. Pay particular attention to Business Wire and other press releases, which have been released directly by the company. The company’s website can also be checked for news releases, which some prefer. It is a good idea to read recent analytical articles from brokerages and financial pundits about the company and industry, because they may recap pending events and add to our knowledge base. While some will disdain volatility or looking for news, it will over time greatly improve both our results and their consistency.

• 15/10% Rule: look for a news event.
• During earnings season, IV typically spikes due to the oncoming earnings report; at this time, an earnings announcement is the first thing to check for.
• A high rate of return for the period remaining to expiration (at the time of this writing, higher than 6% for 30 days) suggests either spiking IV or a comparatively volatile stock.

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The author has no position in any of the stocks mentioned. Financhill has a disclosure policy. This post may contain affiliate links or links from our sponsors.