Choosing A Stock From Those That Have Met Your "Quality" Screen

Once you have a list of possible choices for stocks, then you have to determine which of the stocks have the best risk/return profile. In order to do this, the following steps are used:

1) Create an excel sheet for each stock, for the upcoming option expiration date which would look like the following:

March 2009 Covered Call (PDE)
Current Price	$15.49	Company	Date	Strike Price	Bid	Ask	Average	Dividend	Total Proceeds/Share	Total Proceeds	% Downside Coverage	% Max Upside	$ Max Upside	Annualized Downside	Annualized Upside
# o Shares	100	PDE	Mar-09	$10.00	5.5	5.7	$5.60		$5.45	$545.00	35.18%	-0.26%	-$4.00	422.21%	-3.10%
Total Cost	$1,549	PDE	Mar-09	$12.50	3.2	3.4	$3.30		$3.15	$315.00	20.34%	1.03%	$16.00	244.03%	12.40%
52-week Low	11.38	PDE	Mar-09	$15.00	1.45	1.6	$1.53		$1.38	$137.50	8.88%	5.71%	$88.50	106.52%	68.56%
% Above 52-Week Low	26.53%	PDE	Mar-09	$17.50	0.45	0.55	$0.50		$0.35	$35.00	2.26%	15.24%	$236.00	27.11%	182.83%
		PDE	Mar-09	$20.00	0.05	0.15	$0.10		-$0.05	-$5.00	-0.32%	28.79%	$446.00	-3.87%	345.51%

This table includes the current price of the stock, strike prices both in-the-money, out-of-the-money, and at-the-money. It includes any dividends paid between the purchase date of the stock and the option expiration, and the current option bid/ask spread. These values allow you to calculate the "downside coverage" as well as the "maximum upside." As you can see, the greater your downside coverage (or the further the stock can fall without you losing money overall) the smaller your possible upside.

2) Once these charts are made for each of your stocks, then you have two options depending on both your time horizon for holding the stock, and your appetite for risk. If you are afraid that the stock could go down quite a bit in the short term, it may be better to sell a call which is more "in-the money" in order to have more protection in case the stock goes down. On the other hand, if you think it is more likely the stock will go up, it is better to sell an at-the-money or out-of-the-money call and reap the benefit of the call premium, as well as part of the appreciation of the stock. For the purposes of my portfolio, I do not favor one of these options over the other, it purely depends on my view of the future growth prospects of the company.

3) Now that you have an idea of which stocks have the best risk/reward profile, you must choose how long you want to hold them for. In my view, this is based on the current market conditions. In a bear market such as the one we are currently in, I am of the opinion that for short term options, it is better to sell in-the-money calls, and benefit from high downside protection, while for long term options, selling at or out of the money options, which will both decrease quickly in value (which is good for you) due to the time premium, and allow you to profit somewhat from the appreciation of the stock.

4) A key point in all of this, is to make sure that your portfolio is also somewhat diversified, so that you do not have large exposure to one area.