The Fundamentals of Options

What’s the best way to pick option plays?

While there are probably hundreds, if not thousands, of different answers to that question, now is not the time to get overly sophisticated. I like to keep it simple, and I think you will, too.

Longer-Term Option Plays Are Key

In my options service, Easy Money Options, we focus on longer-term option plays. That way, our positions have plenty of time to work out while allowing powerful, longer-term forces to come into play.

What forces am I talking about? That’s easy: fundamentals.

Fundamentals are the basic forces that drive companies, like product sales, position in the marketplace and how well management is doing. Fundamentals also include what sectors and industries are poised for a move, as well as the broader outlook for the economy.

I like to look at a company’s fundamentals as if looking at a garden. If that garden has been planted in good soil, has the right mix of plants for its climate and is maintained by an involved and intelligent gardener, it has a good chance to grow and prosper. If it doesn’t have those things, it will wither and die.

When a company does business in a growing industry, has the right mix of products and services and is driven by solid management, it has a good chance of success. Without those things, you can pretty much forget it.

I know what you’re thinking: Fundamentals can include a ton of factors. But the most powerful of these factors can be boiled down to one simple idea…

The Best Companies Make the Best Option Plays

Almost sounds too good to be true. But the fact is option plays that focus on the best companies have huge chances at success.

Now, if we weren’t focused on the longer term and were jumping in and out of option trades numerous times a day, it really wouldn’t matter how good a company was. We wouldn’t be in the trade long enough for that to make a difference.

But since we focus on longer-term option plays, those fundamental forces can play a huge role. In fact, they often mean the difference between making a ton of money and getting absolutely clobbered.

Let’s dig a bit deeper…

The First Big Step

The fun thing about fundamental analysis is that most people are already pretty handy at it. After all, you can’t go to the grocery store or the gas station without hearing about high gas prices or how a couple of bags of groceries just don’t go as far as they used to.

You also probably can’t help but hear about how — in a dull economy like the one we’re in right now — there are hints of cutbacks in workers and professionals. Plus, you may already hear talk about how some of your local businesses may be holding tight on expansion until things start to look up.

And of course, you can’t get away from hearing about the subprime mess, the ups and downs in banking and the ever-popular role of the Federal Reserve in managing the economy.

And if you’re one of those people who reads The Wall Street Journal — alongside your latest edition of Penny Sleuth, of course — or listens to the pundits on CNBC, you’re learning about nuances in the economy that weren’t anywhere near common knowledge just a few short years ago.

The fact is all of these economic factors are key forces that fundamental analysts look at every day.

Just like those analysts, you’re hearing about changes in prices, the outlook for jobs, whether businesses are expanding or not and the management of domestic and global money policy.

In other words, you already know a ton about the broader economy, a big first step in fundamental analysis.

What kind of economic factors do I look for? I keep to the basics. If there is reasonably strong global growth — like there is right now in the 4.5% area — then there is strong support for company growth down the road. And that’s a big plus for higher share prices.

Now, in the old days, if growth in the U.S. were projected to be a measly 1.3%, as it is right now, I’d be a bit worried. After all, way back when, as goes the U.S., so goes the rest of the planet.

But with super-hot spots like Asia creating millions of buyers and markets overnight — and the increasing global marketplace for just about every business — the world pretty much stands on its own two feet these days.

Reading Inflation

I also take a look at prices and where they’re headed. A little rise in prices — called inflation — is actually a good thing. After all, without earning a bit more this year than last, it’s tough for individuals and businesses to grow.

But you don’t want too much. Inflation can absolutely ravage an economy and cause prices to spiral way out of control. In fact, fighting inflation is one of the most important jobs global central bankers have to do.

A good rule of thumb is inflation should hover around 2.5% or so and top out around 4-5%. Right now, inflation in the biggest nations around the world is around 3.5%, so we’re pushing our luck a bit. But inflation in red-hot emerging and developing nations is off the charts, at 8.6%. Need for alarm? Not yet. With explosive growth comes super-normal price increases. But it’s something I keep my eye on.

Inflation is also important for another big reason. When it gets too high, central bankers around the world — like our own Federal Reserve — will try to cool it by raising interest rates. The thinking is that with higher interest rates, it’s more expensive for businesses to expand and for people to spend. As a result, there’s less buying pressure on prices.

Good for share prices? In general, no. Sure, higher interest rates mean costs may be contained, but it also means there’s less money to spend. And that takes a bite out of sales and growth.

Rising rates also mean that interest-related investments — like bonds, money markets and deposits — start to look better and better. And that can take some of the luster off stocks.

Of course, there are tons more economic factors that go into fundamental analysis. But a good start is to keep your eye on where growth and inflation are headed around the globe and in the U.S.

I want to walk you through some more of the key fundamentals I focus on. But let’s leave that for another day. Until then…

Wayne Burritt
Penny Sleuth