6858483M 82A 81R 80K 79E 78T 777675P 74R 73I 72C 71E 70S 696867O 66F 656463S 62T 61O 60C 59K 58575655545352
limited loss zone15-MONTH TIME TO EXPIRATION* Based on closing prices as of October 22, 2004; source: www.cboe.com
Figure 8–3 Profit and loss zone, short option straddle.Chapter 8 Combination Conservative Techniques
221
Maximum Advantage: Large-Point DiscountsThe 18.2-percent return and discount of the net price down to $52.25per share is a good start for this position. Referring back to possibleoutcome scenarios, a short straddle such as this is appropriate onlywhen you want to create exercise. It remains possible to roll out of thesepositions, depending on the direction of price movement. For example,if the stock’s price rises, you could close the 15-month 70 call andreplace it with a 75 call expiring 3 months later. If the stock’s priceremains below the 70 put strike price, the 15-month 70 put could bereplaced with a 65 put expiring 3 months later.Rolling to avoid exercise extends exposure time but also increases profitpotential. The short straddle is conservative as long as the usual qualifications apply: you want to keep shares of stock and add to your holdings,you have qualified the stock in fundamental terms, and you consider theput strike price (discounted by short option premium) a fair price levelfor the stock. In the example, the 15.40-point price discount takes thepotential average basis in stock far below the recent historical tradingrange for Fannie Mae as of the analysis date, which ranged between $60and $80 per share over the past 12 months. If you purchased 100 sharesand wrote this straddle at the price shown, an exercised put would produce an average basis in the stock of the following:
Purchase price, 100 shares
$6,765
Option premium received
–1,540
Purchase price, exercised put
7,000
Total cost, 200 shares
$12,225
Basis per share
$61.13
Risk is limited on the downside. Exercise of the 70 put occurring at anypoint between $61.13 and $70.00 per share would leave you with acquiredstock at or above then-current market value (not considering tradingcosts). But what occurs if the value of the stock falls below $61.13 pershare? If we consider the net of about $60 per share to be a low tradingrange for this stock, what does it mean when prices fall below that level?
222
OPTIONS TRADING FOR THE CONSERVATIVE INVESTOR
Rescue StrategiesIf you write a short combination or a short straddle, it is conservativeas long as you own 100 shares for each call written. This assumes thatthe fundamental value of the stock has been established and that youwould welcome exercise. In the preceding example, we established thata straddle on Fannie Mae produced an annualized yield of 18.2 percentand discounted the cost of stock to $52.25 per share. However, if theput were exercised, the true net cost of 200 shares (original 100 plusadditional 100 shares put to you) would end up at $61.13 per share.If the stock’s market value were to fall below $61.13 per share, you wouldhave a net loss. Remember, if your assumed fair price level for the stockis accurate, the decline may be viewed as short-term—as long as the fundamental strength of the company does not change. The price will mostlikely rebound above $61.13 per share at some point in the future.
Three Valuable Rescue StrategiesIf necessary, you can employ one of three rescue strategies involvingoptions:1. Sell covered calls. The most basic rescue strategy is writing covered calls. With an increased number of shares, you can recovera paper loss and create a net profitable position, even if the callsare exercised. Referring to the previous example, we saw that27-month calls for Fannie Mae were available for about $6.60and were 12 points out of the money (refer to Table 8–1).Assuming you could find a similar situation with stock at $55per share and your basis at $60, writing 65 calls and getting apremium of 6 points each would be profitable. Selling the covered calls reduces your basis from $61.13 to $54.13. If exercised,you would earn a total of $1,200 per call before trading costs;writing calls is a viable rescues strategy.2. Repeat the combination or straddle. Once your previous shortpositions have been closed, exercised, or expired, you are free towrite additional combination or straddle positions. If you continue to believe in the fundamental value of the stock, you end
Chapter 8 Combination Conservative Techniques
223
up with 200 shares at reduced basis (in the preceding example).You could write new covered calls and uncovered puts, furtherreducing your basis while increasing your holdings in the stock.This proposal assumes that, at reduced price per share, youremain willing to acquire more shares in the stock.3. Sell uncovered puts to reduce basis further. Yet another alternative is to gain additional premium income by selling puts. Forexample, you have 200 shares, and you are willing to increaseyour holdings to 300. Your 200 shares have an average basis of$61.13 per share. If you write a 55 put and earn a premium perput of 6, or $600, it would reduce your net basis to $55.13 pershare on your 200 shares. If that put were exercised, your overall basis would be $69.09 per share:$61.13 (2) + $55.00 = $59.09 (300 shares)As long as you have confidence that this adjusted basis remains a fairprice for the stock, selling puts is a good form of contingent purchaseand an effective rescue strategy. In the case of Fannie Mae, recall thatthe historical trading range was between $60 and $80 per share. If youuse that to measure average cost, as proposed above, your a basisremains below the typical trading range of this stock.In the next chapter, we conclude with a review of sound stock selectionfundamentals with option strategies in mind.
224
OPTIONS TRADING FOR THE CONSERVATIVE INVESTOR
9STOCK SELECTIONAND THE OPTIONCONTRACTSelecting stocks based on your risk profile is never an easymatter. In this chapter, we provide conservative guidelines forsmart stock selection. The worst criterion for picking a stock isbasing the selection on option premium levels. By definition,high option premiums represent greater market risk, so optionpremium levels are good indicators of stock market risk. Wepropose conservative standards, offer guidelines for managingthe tax complexity of options trading, and suggest methods forusing options as a part of your conservative theme.
225
W
hen all possible option strategies are considered in the contextof your conservative profile, what are the criteria for determining which (if any) strategies are appropriate? A recurringtheme in this book is to focus on risk profiles and remain faithful toyour original investing themes, limitations, and capabilities.No option strategy is appropriate if its use requires you to alter yourrisk profile. However, if you discover while investigating options thatyou are willing and able to take on higher risks than you had assumedpreviously, then you need to reevaluate all of your underlying assumptions. The process of defining risk tolerance is and should be an everevolving process. Risk level is determined by a broad range of othermatters: knowledge and experience as an investor, personal income andcapital, change of job, marriage, birth of a child, divorce, death of afamily member, changes in a family member’s health.As your personal career and life events emerge, your risk profile changes aswell. This is natural and expected. The problem some investors experienceis that when they suffer losses in their portfolio, they may take recklessactions, accept greater risks, and go through a transition from moderateor conservative to a more speculative profile. The intention, in many ofthese instances, is to gain back the losses as quickly as possible, but that isa mistake. There is wisdom in the advice to chess players: When you lose achess piece, don’t make the mistake of attacking to try and even up thescore. When you are behind in points, the smart thing to do is to go on thedefensive, become more cautious, and look for ways to protect yourremaining position. The same advice applies to investing, especially if youdefine yourself as conservative. It is a mistake to try to recapture losses bytaking on more risks. Everyone loses; the wise attitude is to look for waysto reduce future losses by protecting capital, insure paper profits andexploit market price swings, and seek conservative strategies that improveoverall performance. These goals are all met by the thoughtful and sensible application of the option strategies explained throughout this book.
226
Remembering Your Conservative Profileas a PriorityEven with a thorough grounding in options and their context, you mustcontinually remind yourself of your personal goals, limits, and standards. The market is a playground full of temptations, and many wellintended investors become distracted from their sensible goals anddrawn to the many dangerous but exciting high-risk, exotic, and potentially profitable schemes that are so visible and so popular.Conservative, fundamentally based strategies are not terribly exciting,especially in the media-focused market environment. The media tendsto emphasize index movement, substantial point change in high-profilestocks, and market rumors and news. Even fundamental news like earnings reports is focused on variation between analysts’ predictions andactual outcome rather than on the value of the company as a long-terminvestment. This scorekeeping is the popular game on Wall Street—atthe expense of less exciting but more important fundamental analysis.The market, as a media-driven “store” containing a vast array of products (stocks, bonds, commodities, and derivatives in many forms) isindeed a distracting place. It is very much an open market with barkerstempting buyers with promises of easy riches. Little, if any, attention ispaid to the analytical, detail-oriented fundamental study of a company’s financial statements and other financial information. Why shouldthe media highlight a subtle change in a capitalization or working capital ratio? It is easy to report a two-cent variation between earnings andpredictions or a four-point movement in the stock’s price. So, your difficulty in maintaining your focus is a constant in the market. Your success, which may be defined in terms of losing less often than average,depends largely on making good decisions at the right time.
Dangers and Pitfalls in Using OptionsOptions, like so many aspects of the market, offer a wide array of temptations. The speculator is drawn to the positive aspects: leverage of capital withthe potential for fast profits, often in triple digits, and the fast pace of themarket. They rarely pay attention to the other attributes of risk associated
Chapter 9 Stock Selection and the Option Contract
227
with options: equally fast losses, long-position disadvantages, and the virtualimpossibility of profiting from speculation consistently.It is always tempting to go for fast and easy profits at the expense ofconservative standards. However, you know that, by definition, yourstandards include resisting that temptation. You are aware that opportunity and risk cannot be separated and that those potentially highreturns are usually accompanied by a similar high scale of risk. Whilethere are exceptions within the options market, conservative strategiesall have a common attribute: they are geared toward augmentingreturns and protecting positions in your portfolio.A most important theme is to remember how easy it is to lose sight ofyour original goals. It is easy to slip out of your conservative mode,allowing risks to expand unintentionally, and to become fascinatedwith the potential of a particular options strategy. Throughout thisbook, we emphasized how important it is to test every strategic choiceagainst the sound, conservative risk profile you have already establishedin your portfolio.
Allocation by Risk ProfileSome people believe that a sensible way to use options is to create a basein their portfolio at some percentage of capital. For example, they maydevote 80 percent of their capital to conservative investments. Theremaining 20 percent is “mad money,” put aside to give in to temptationand to seek high returns along with high risk. However, this is pooradvice. The majority of outcomes involve losing that 20 percent. As analternative, why not invest 100 percent of your portfolio in high-valuestocks and then use options conservatively to augment returns, protectlong stock positions, and take advantage of market price overreactions?It makes far more sense. You will experience consistent current yieldsusing strategies like contingent purchase, covered calls, and short combinations (involving covered calls and uncovered puts, which is in effecta contingent purchase and a contingent sale opened at the same time).These specific uses of options do not add to market risk. Their overalltheme is easily summarized: they are designed to provide conservative
228
OPTIONS TRADING FOR THE CONSERVATIVE INVESTOR
returns consistently over time. Of course, you will occasionally haveshares of stock called away and lose the opportunity to make a higherprofit. So, in exchange for the occasional lost opportunity, you canmodify your portfolio to create option returns, a trade-off you willprobably view as an obvious good choice.Without exception, though, these strategies (along with the use of longputs or short calls for portfolio insurance) must always conform toyour long-term conservative risk profile. Your purpose is to buildwealth, not to speculate recklessly; so the use of options has to berestricted to those strategies that enhance your existing long stock positions or that expose you to the purchase of stock that you desire toown—either more shares of existing issues or shares of other stocksthat have been prequalified as appropriate within your portfolio.Some people, notably those who have not examined the conservativepotential in the option strategies explained in this book, may argueagainst the concept that options can and do augment the conservativeattributes of your portfolio. One conclusion is impossible to avoid: notonly are some option strategies conservative, but not employing themputs your portfolio at risk. For example, when a stock’s market valuerises far above its normal trading range, you naturally expect a shortterm correction. This is the perfect time to write covered calls. Youexpect the stock’s value to retreat, but if strike price is properly selectedwith current higher-than-expected prices in mind, exercise itself wouldcreate a substantial profit. If, instead, you buy puts for insurance, youalso protect the paper profits by timing your decision based on a keenawareness of trading range versus current price spikes. The same observation is true when prices decline rapidly. A downward spike is a buying opportunity. The traditional method, buying additional shares, is adifficult decision to make when prices have fallen because everyone isuncertain about the short-term volatility and potential for furtherdecline. An alternative is to buy calls or, even more conservatively, tosell out-of-the-money puts. In either event, you create the potential tobuy more shares and average down your basis in the stock withoutplacing more capital at risk.
Chapter 9 Stock Selection and the Option Contract
229
Using Options to Reduce Market RiskThese are conservative strategies. The ultimate conservativeapproach—the short combination or short straddle explained inChapter 8, “Combination Conservative Techniques”—creates a position in which even a drastic decline can be rescued with additionaloption positions. When you create a large protective range through theselection of option strategies, you reduce market risk rather thanincrease it. There are many instances in which just holding shares andtaking no action becomes high-risk, even in a conservative portfolio.The long-term approach traditionally has shunned strategies based onreaction to short-term price movement in favor of holding onto conservative growth investments. That plan certainly works; however, average returns on a conservative portfolio are less than 10 percent. Bydefinition, a conservative portfolio is unlikely to exceed the marketaverages. Options can help you to adhere to your conservative risk profile while also beating the market consistently and substantially.We have all heard wild promises about double-digit and even tripledigit returns by applying an investing “system” of one kind or another.Experience (meaning “loss”) has taught us that schemes do not workand that there are no easy or sure-fire ways to beat the market. Even theconservative use of options requires diligence, learning the techniques,mastering terminology, and becoming more knowledgeable than theaverage investor. Some conservative investors are content to buy sharesin blue chips and to place the balance of their capital in a moderategrowth mutual fund. While this traditional approach may enable you toexperience average growth or even to outperform long-term averages, itis not spectacular.
Temptation to Select Most Volatile StocksWhen your conservative portfolio does not perform as you expect,what can you do? Some investors are tempted to sell lackluster stocksand go with more exciting, more volatile issues. The idea is that youcan experience profits more rapidly, make up for past losses, and outperform the market. In fact, though, this approach is an abandonment
230
OPTIONS TRADING FOR THE CONSERVATIVE INVESTOR
of conservative principles. You need to continue to carefully selectvalue stocks and then protect their equity value. That is the true conservative strategy.Investors who like the idea of using options also face danger if andwhen they pick stocks inappropriate for the conservative risk profile.If you shop option premiums with the idea of buying stock and thendiscounting your purchase price with covered call writes, you are taking the wrong approach. A conservative application of optionsrequires that you first select stocks based on fundamental analysis andcomparison; that you pick stocks with lower-than-average volatilityand the potential for price appreciation; and that the capital structure, revenue and earnings, PE ratio, dividend history, and other indicators of your stocks are a good fit for your conservative standards.Then, you use the various conservative option strategies to protectequity and enhance current income. Remember, using conservativeoption strategies on risky, volatile stocks contradicts your standards.The first rule is, pick your stocks carefully and then identify methodsfor protecting their value.
Creating a List of Potential InvestmentsThere is no shortage of high-quality stocks. By applying conservativeprinciples, you can easily identify at least 10 to 20 stocks you wouldlike to own. You might not be able to afford to buy shares of all ofthem, but that is not the point. Once you develop your list of potentialquality-growth investments, you can buy shares in several of thosecompanies; if a covered call strategy ends up with stock called away,that is not a complete loss. The transaction frees up capital that can bereinvested in the stock of another company on your list. As long as youcontinually maintain that list of strong candidates based on soundfundamentals, you should never have a shortage of good value investments that you can buy and hold, buy and cover, or apply in contingent-purchase strategies. It is a mistake to believe that there are only alimited number of “good” stocks available at any given time; more likely, there will be far more issues than you can afford to own, which givesyou great flexibility in moving capital from one stock to another if youneed to. A long-term buy-and-hold strategy makes sense as long asChapter 9 Stock Selection and the Option Contract
231
fundamentals remain strong, but does not mandate that you avoidselling stock under any circumstances. The proper selection of conservative option strategies may result in shares being called away, but aslong as you experience a higher-than-average current annualizedreturn, it is a successful transaction.You gain further flexibility in options trading when you own morethan 100 shares of stock. This gives you the chance to vary the use ofoptions, to cover partial holdings, and to change the mix of shortoptions against long stock when you roll forward and up. You can alsowrite covered calls with a mix of expiration and strike prices, or makecombinations and short straddles more flexible and interesting with asimilar mix.
Creating Sensible Conservative StandardsAssuming that you accept certain options strategies as fitting withinyour conservative framework, it is worth asking again, What is the definition of a conservative portfolio? In other words, what are the basicstandards for stock selection? We already know that picking stocksbased on potential option premium levels is a mistake that should notenter into the equation at all.
The Five Conservative Standards for Stock SelectionThere are a few well-understood conservative standards for pickingstocks. These analytical topic areas should include, at the very least, thefollowing five criteria:1. Revenue and earnings trends. The quarterly and annual rate ofgrowth in revenues and consistency in earnings is always astarting point in fundamental analysis. In spite of the popularity of some dotcom stocks whose companies never earned aprofit, the fact remains that conservative investing is based onconsistent growth in the operating statement: increasing revenues, well-controlled ratios of cost and levels of expense, andstrong earnings.
232
OPTIONS TRADING FOR THE CONSERVATIVE INVESTOR
In analyzing these trends, pay close attention to the gross profitand expenses. Gross profit should remain consistent even whenrevenues change significantly. Expenses should remain as constant as possible in relation to sales. You may expect someexpansion in expenses as corporations diversify, acquire newlines of business, and expand geographically. But the ratiobetween expenses and revenues should not be negative.Revenues should outpace expenses, and when they do not, it is asign of trouble. When you see sales flattening out or falling, butexpenses continuing to rise, that is a very serious problem. Wellmanaged corporations should put the brakes on expenses whenrevenue trends slow down.The revenue–costs–expenses–profit interaction is the essentialfundamental indicator that should be the starting point in anyfinancial review. This means that when a corporation has a netloss, there is a fundamental problem. One-time charges mayexplain the loss, and if that is the case, those charges should beadjusted for the purpose of performing year-to-year trendanalysis of the operation. However, if net losses continue fromone year to the next, it is only a matter of time until capitaldeteriorates. Expanding net losses are a warning sign that a oncevaluable investment has peaked and is on the decline.2. Capitalization and working capital. The most overlooked aspectof a company’s ability to remain competitive is its relative capital strength. If a company is depending increasingly on longterm debt to fund growth, that means that an increasingportion of future earnings will have to go to debt service, leaving less capital for expanded operations and dividend payments. So, a negative trend in capitalization should be analarming signal in your conservative portfolio. Tracking working capital is another method for judging a corporation’s financial health. Changes may be subtle, but trends can be observedover time, and what you seek is a company that is able to anticipate cyclical change through proper planning and workingcapital management. A change in these indicators is an earlywarning sign of a shift in long-term capital trends.
Chapter 9 Stock Selection and the Option Contract
233
Initial review might indicate that a company is healthy in termsof working capital when it is simply not the case. For example,you may notice that a corporation maintains a strong 2-to-1current ratio (comparison between current assets and currentliabilities) from year to year, while reporting declining sales andlarge annual net losses. How can that be? A more detailed reviewmay show that the corporation has been increasing its longterm debt (which is not part of the current ratio) as a means ofmaintaining its working capital ratio. It is a popular practice tocheck working capital without also reviewing the long-termdebt trend. However, that trend is essential and can prove thatduring periods of declining sales and profits, debt is being usedto bolster the balance sheet. Ultimately, the ever-growing longterm debt affects financial health, so capitalization trends haveto be reviewed along with the current ratio.3. PE ratio trends. The PE ratio is a perplexing indicator. It combines technical (price) and fundamental (earnings) in a single“value.” But it is troubling because the price is current butearnings may be several months out of date. With this in mind,the PE is best reviewed as part of a trend over time. As PE inches upward, you may conclude that investors are placing toomuch value in future growth potential. A more revealing formof PE than current price and latest earnings is to comparequarter-end closing prices to quarter-end earnings, and thenreview that version of PE over a series of fiscal quarters.History has demonstrated that lower PE stocks outperformhigher PE stocks with remarkable consistency. But, by definition, the higher PE also indicates greater market interest. Thus,this hybrid technical/fundamental indicator is a valuable meterof market sentiment. When the PE begins rising above its historical range, it may also indicate that the price of stock is outpacing anticipated future growth. Because the PE is a reflectionof earnings multiples, the higher the PE, the more concern youshould have regarding the long-term value of stock.Another factor that can distort PE is the degree of one-timeadjustments needed in the reported profits of the company. Ifearnings per share (EPS) includes noncore items (see number 4,
234
OPTIONS TRADING FOR THE CONSERVATIVE INVESTOR
below) or one-time extraordinary adjustments, then the PE islikely to be inaccurate and unreliable as an indicator. You mayneed to adjust reported earnings in order to arrive at a reliablePE for the purpose of trend analysis.4. Core-earnings-based analysis. The need to make adjustments toreported financial results makes all the difference in fundamental analysis. For example, if current net earnings include proceeds from the sale of a business and other capital assets, profitfrom an accounting change, or pro forma earnings on investedpension assets, those items should be removed from the analysis. If employee stock options were granted in the current yearbut are not included as an expense, their value should bededucted from reported net earnings. In many cases, core earnings adjustments can significantly change the fundamental conclusions you will reach about a particular company or aboutcompany-to-company comparisons. The intention in makingcore earnings adjustments is to identify the true core earningsso that comparisons from period to period or between corporations are valid.If you do not calculate core earnings adjustments, all other fundamental indicators are unreliable as well. For example, the PEratio compares the stock price to earnings per share; however, ifearnings per share is distorted, then the PE will be distorted aswell. One solution is to compute core earnings per share and usethat in calculations of the PE. As a result, the core PE ratiobecomes an indicator of the company’s long-term growth trend.5. Dividend history and reinvestment plan. The history of dividendpayments and the current yield are very important indicators.In a comparison of various options strategies, for example, wedemonstrated that the dividend yield makes a big difference inwhich company you select. If you limit your selection to dividend achievers, those companies that have increased dividendpayments every quarter over the past 10 years, you naturallypick from among the strongest value investments available. Ifyou also limit your list of potential investment candidates tocompanies that have DRIP plans, you can achieve a compoundrate of return on dividend income, which over time adds great
Chapter 9 Stock Selection and the Option Contract
235
value. You will find plenty of conservative investments thatmeet these criteria, and it is an excellent method for narrowingdown the list of candidates.This list is only a starting point—the bare minimum of fundamental indicators that you need. In your own conservative analysis program, you mayalso use any number of other indicators you find useful, including a broadrange of balance-sheet or income-statement ratios. management indicators. or combinations of fundamental and technical trends. For example,in judging the safety of a company, the fundamentals are of paramountimportance, but you should also examine technical volatility and impliedvolatility (both in stock and option price and volume trends).
Maintaining Fundamental ClarityThere is a tendency among investors to believe that good values are difficultto find. However, confusion arises in an attempt to define “value” in themarket. Some investors believe they should buy stocks that double in valueimmediately after they purchase shares. So, even conservative investorsmay end up chasing short-term profits and conclude that it is difficult tofind value—by a double-in-value definition—with any consistency.Under a truly conservative standard, a quality investment should bedefined as a strongly capitalized, well-managed, profitable, and competitive company whose stock has performed strongly and consistently,and whose fundamental and technical risks are a good match for theconservative profile. Under this definition, there are many good valuesto be found in the market. The argument against covered call writing—that you risk losing stock—is often premised on the idea that a particular stock, once lost, cannot be replaced. In fact, though, good valuesabound and can be located using fundamental criteria. You may wantto develop a list of prequalified companies. The list may be far largerthan the number of stocks you can afford to own, but it broadens yourstrategic range, and you come to realize that having “good” sharescalled away is not truly a loss. As long as you can consistently earn current returns in your portfolio and maintain a conservative standard,there is no real lost-opportunity problem. You simply replace oneopportunity with another.
236
OPTIONS TRADING FOR THE CONSERVATIVE INVESTOR
Distinctions: Risk Standards Versus Brand LoyaltyThe clarity with which you view your long-term goals has everything todo with how you manage your portfolio. A second tendency amonginvestors is to develop a “brand loyalty” to the stocks they own. Closelyrelated to this is an aversion to some companies based on noninvestingcriteria. For example, some people hate Wal-Mart, Microsoft, orHalliburton to the extent that they will never buy shares in those companies. Some investors are faithful to IBM, Sears, or Kodak. These loveor-hate opinions often are not based on fundamental analysis but onsome personal, social, or political opinion. To maintain clarity, it isadvisable to avoid investing in companies that you either love or hate, ifonly because strong feelings about a particular company cloud judgment. You can make more objective decisions about when to buy, hold,or sell a company’s stock if you are neutral about its management, policies, politics, or social impact. For example, if you once owned a smallretail store and you were forced out of business because Wal-Martopened a Supercenter across the street, you may not be able to objectively evaluate the investment value of Wal-Mart stock. If you swear byKodak products for your personal use, you may not be able to analyzethe company’s ability to compete in the digital camera market.Given the large number of excellent quality investments, it makes senseto limit your analysis to those companies that you can evaluate objectively. In stock selection as well as in a decision to employ option strategies, there is plenty of fundamental analysis to be done without alsostruggling with personal feelings about the company itself.Once you pick companies that qualify for your fundamental, conservative standards, you also want to maintain clarity on two other levels:stock ownership and the use of options. The decision to hold or sellshould be based on consistency in fundamental indicators or on emerging changes in trends. A particular stock might be a good candidate foroption strategies; this does not mean that the stock continues to qualify as part of your portfolio. It makes sense to sell shares of stock as soonas the risk factors change and those factors are clear and precise, basedon financial information and capital strength, not on technical aspectsof option values.
Chapter 9 Stock Selection and the Option Contract
237
The second form of clarity is the use of options. There are a limitednumber of appropriate strategies in your conservative portfolio, andonce you have set standards limiting their use, it is important to avoidthe temptation to wander from those limited, conservative applications. To review, your criteria may include the following:1. Use options only for stocks you own or want to own.2. Use short calls only if and when you are willing to accept exercise.3. Use short puts only if you are willing to buy additional shares,either through a contingent-purchase plan or when marketmovement presents buying opportunities.4. Premium value from writing short options should be at orgreater than a minimum annualized return (we used 10 percentas a minimum in our examples).5. Long options may be purchased to (