Option Investor
Educational Article

Only Trade The Good Ones

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By David Popper

Once upon a time, while leaving an Orlando Magic basketball game, I noticed people handing out books. I was handed what turned out to be an investment book by a then current "guru." The book touted "secret" investment techniques "that only the rich know." These "secret" techniques were none other than simple option strategies such as writing covered calls, selling puts, buying calls, etc. I read over the book one Thanksgiving and became intrigued with the notion of writing covered calls. In this book, the "guru" made it sound so easy. He claimed that you could make between 14% and 40% per month employing this strategy. All that you had to do was buy stock that had a call premium of 10%, buy all of the stock that you possibly could including using most of your margin, and sell the calls. Why in a few short years you too could be a millionaire.

I was given a web site which listed stocks that had the highest call premiums but had no real fundamental or technical analysis. I found Rastergraphics. The stock sold for $5 at the time. The $5 call for the current month was $0.50. Ah, the color of money. That was all I needed to know. Who cares about what product or service Rastergraphics makes? Who cares who its competitors are? Who cares if it makes money? Who cares what the chart looks like, I made 10%. I felt great until 2 weeks later when the company's share price was cut in half. Two months later it was delisted.

I made the same mistake that a na´ve teenager would make on the dating scene. She is beautiful-I'm in love, even though I don't know her name, background, family or anything else. It didn't take more than one error in dating to gain some discretion. So too, the Rastergraphics experience taught me to realize that premiums were not everything. Earnings matter. Long term prospects matter. The chart matters. In short, you should only trade quality stocks that you wouldn't mind holding long term. If you only trade stocks that are worth holding for the long term, you are never worse off than a long term holder of a quality stock. You, in fact, are in a much better position because as a call writer, you are always collecting premium. The past few years have demonstrated that quality stocks, particularly in the high tech area, will have violent down times followed by violent upward moves. Purchasing quality stocks and continually writing calls should keep you profitable over the long run.

In short, the "guru" was right, writing calls is an effective cash flow technique. The "guru," however, didn't tell me the rest of the story. Rastergraphics episodes are the other half of the story. Margin can make it worse. Short-term covered calls are effective, by itself or in combination with other strategies, if and only if used in light of basic fundamental analysis (earnings) and technical analysis (relative strength and chart analysis). I wish that I could say otherwise, but nothing substitutes for homework and nothing substitutes for quality.

So how do you do your homework? An easy way is to use the system that I discussed two weeks ago. I began to use one fundamental measure and one technical measure. The fundamental measure is EPS (earnings per share). As I explained, in Investors Business Daily (IBD), each company's EPS is listed. IBD measures the EPS by comparing a company's earnings in the two most recent quarters and comparing them to the same two quarters from the year earlier. Then, the earnings growth rate for the past 5, 4, and 3 years are evaluated. The results are compared to all other stocks and are rated on a scale of 1 to 99, with 99 being the best. For example, if a stock is rated with a 90 EPS rating, it outperformed 90% of all other companies in earnings growth. I insist that a stock have at least an 80 EPS. The technical measure that I use is relative strength (RS). IBD measures the stock's price change over the past 12 months and once again compares it with the universe of stocks. If a stock has a 90% RS, then it has outperformed 90% of the stocks over the last year.

Once again, I insist that a stock have an RS rating of 80%. Once a stock is selected, I then try to make my trade based on the chart. Is the stock trading above its 10 day, 20 day, 50 day, or 200 day moving average? Is the stock basing or is it topping? Is the volume greater on up days than it is on down days? This is not heavy duty technical analysis, this is the basics. The point is, a Rastergraphics situation can be avoided with a minimum of effort. That is, simply picking good stocks at technically reasonable times. If you are not day trading, precision with entry points is not near as critical. The bottom line is, you should insist on only trading the good ones.

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