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Options: Picking Stocks For Covered Calls

You can earn double-digit returns consistently with covered calls (on an annualized basis). In fact, the shorter-term expirations yield more, so you're better off writing several smaller premium calls per year than one or two big-dollar but lower-return strikes.

A common error is picking stocks based on premium of the call. The more volatile the stock, the more implied volatility in the option and herein lies the problem. If you pick stocks just to write covered calls, you may be taking on more risk than you actually want. In fact, the process should be the other way around: First, pick high-quality companies with exceptional long-term fundamentals, and then use these for covered call writing and other option hedging strategies.

If you are conservative, use four basic guidelines for picking solid, safer stocks for covered call writing:

1. Revenues and net profit should be rising every year. When you see erratic operating results, net losses, or falling profits, you should be troubled. Look for stocks to buy in profitable and competitive corporations. Even if both revenues and net profits are rising, make sure the net return is remaining consistent (net earnings divided by revenues). This test reveals whether a company is keeping pace with growth by continuing to control costs and expenses.

2. The debt capitalization ratio should be declining or staying steady. Avoid companies whose debt ratio is higher than the average of its competitors, especially if that ratio keeps rising every year. Total capitalization (long-term debt plus equity) should include a sensible mix between equity and long-term debt, but when the debt side starts climbing, it gets more and more difficult to get out of the hole. This trend means future earnings have to go increasingly to debt service, meaning less to fund growth or pay dividends.

3. The annual P/E range should be moderate. As a general rule, look for a P/E ratio between 10 and 25. Any P/E under 10 indicates lack of interest in the company; any P/E above 25 starts to get expensive. Also, don't just look at today's P/E. Compare high/low P/E levels over several years. Look for consistency in the high-to-low range.

4. Pay attention to dividend history. If all else is equal, select the company with the higher dividend. The yield is the dividend per share divided by current price per share, so the yield you earn is based on the price when you buy. Focus on exceptional yields, between 4% and 6%. There are plenty of high quality companies in this range. Also track the payout ratio, the percentage of annual earnings paid out in dividends. If a company is increasing its dividend per share but the payout ratio is declining, that is a negative trend. A positive trend involves rising dividends and a steady payout ratio, reflecting sharing of annual growth with shareholders.

Once you qualify companies in terms of value and quality, buy shares and then begin writing covered calls. It makes sense to pick the companies first, and then write covered calls, instead of the other way around.

Michael Thomsett blogs at TheStreet.com, Seeking Alpha, and several other sites. He has been trading options for 35 years. He also teaches on the Candlestick Forum website. To check membership, go to Candlestick Forum membership.His new book can be viewed at tinyurl.com/z44kzlu