Analyzing a Covered Call Trade by Barry Bergman, Director of Research, The Blue Collar Investor Corp.

Covered call writing trades can be analyzed from many perspectives. Each analysis represents an enlightening experience as we all learn from each other and share ideas and conclusions. We recently received a series of emails from one of our more experienced and savvy premium members regarding several trades he executed a short while ago. I asked Barry Bergman, Director of Research for The Blue Collar Investor Corp. to respond. Barry spent countless hours re-tracing trade executions, evaluating possible alternative maneuvers and potential lessons learned. Although trades can be analyzed in many ways, I felt that posting the email trail (with the member’s permission) can benefit many of our members. For new members some of the content may seem a bit overwhelming so I suggest you print out the article and reference it from time to time. Here now is the trade history for INVN starting with the initial email: 

First, the original email and trade history…

SUBSCRIBER EMAIL #1:

Alan,

This requests your thoughts about a trade I made that didn’t work out well at all. I lost about 20% of the initial investment in two months. Last month you published a really useful summary by Barry about a trade on CMI that didn’t work out. I wondered if maybe someone on your team would do the same for this trade. If you’re willing to do it and if you want to publish it, it would be fine by me.

The trade details and my thinking at the time of each trade are in the attached Word doc.

Thanks in advance.

INVN Covered call historyINVN- Technical chartINVN Technical chart

INVN Technical chart

• I got in on a good entry point with an up trending stock
• I tried for a couple of doubles on pullbacks.
• I rolled up and out on a positive uptrend.

Any thoughts about what I could have done?
Thanks in advance.

BCI RESPONSE EMAIL #1:
Barry’s initial response:

The BCI system tends to be conservative, with preservation of capital a key component of the methodology. Understanding this…let’s take a look at your trade…

Some initial thoughts…

> As Alan continually advises…stock selection is the most critical element of the BCI
methodology

> I reviewed the Premium Report from 2/17/12…the report published just prior to your
trade entry

– INVN failed the screening process that week
– This means that INVN was not an “elite” covered call candidate that week because…
– The price was at the 20 day EMA
– Both the MACD and Slow Stochastics failed
– No StockScouter rating (not a deal-breaker)
– The stock was only trading since 11/16/11…trading for less than 6 months…Alan
likes to see at least 1 year of price history…stocks with less than 1 year of history
because stocks with less than 1 year history could have higher risk and volatility (also not a deal-breaker)

> INVN then failed to pass the screens per the 2/24/12 report
– Price at 20 day EMA
– Failed MACD and Slow Stochastics
– The stock was only trading since 11/16/11…trading for less than 6 months
– No StockScouter rating

> INVN then failed in the 3/2/12 report

> INVN first appears on the 3/9/12 report with mixed technicals

> Your comment “good entry point with an up trending stock”…
– Just prior to your entry, the stock turned over…not a good sign…could mean that the
uptrend was over. At the time you entered the trade, you didn’t have any idea
whether the stock was pulling back or was, in fact, turning over. You needed
confirmation that this was a pull back.

> On 2/27, INVN closed below to 20 day EMA…this could have been a good time to exit
the trade with only a small loss

> It appears (in my opinion…I could be wrong here) that you were trying to day trade the
covered call…trading/adjusting too soon or over trading

> If you held the trade until expiration on 3/16, the trade would have been profitable

Net/net…
I believe that the primary issue with this trade was stock selection. It did not pass the critical selection criteria until almost 4 weeks into the trade. Also, the stock didn’t have any long term track record/price history…trading less than 1 year (not a deal-breaker but a more risky trade). This trade was then compounded by the adjustment process for the trade.

I think that there are four lessons to be learned from this trade:
[1] Stock selection is the most critical factor to successful covered call trading…follow
the proven BCI methodology
[2] Patience…if you waited a bit longer, the trade would have ended successfully
[3] “Paper Trading” and back testing exit strategies before you commit live cash to the
trades
[4] The initial return appeared to be higher than the typical return the BCI system looks
for, usually 2-4%. In this case it was over 5%. Higher returns are indicative of higher
volatility in the stock.

SUBSCRIBER EMAIL #2 WITH BCI RESPONSE #2 INLINE:

The subscriber then responded to our first pass review of the trade with follow-up questions…

Thanks so much for your response. This is sooooo helpful!!! I really truly appreciate it! I do have a couple of “ah ha’s”, comments, & questions.

1) My big “ah ha” here is that you don’t recommend entering a position from the list that “passed previous weeks & failed current week.” I thought they were there to use, albeit cautiously, until they dropped down to the “stocks removed from running list this week.” I do see it’s in point 4 of the document “running list from the premium report” but I never internalized this point. This is an important misunderstanding on my part but I’m really glad to now understand. It certainly makes my screening process easier, and I hope better.

BCI RESPONSE:
We keep the “stocks removed from running list this week” on the report for readers who may have entered the position previously rather than just dropping the stock. In many cases the stock comes back and continues on the “Running List.” The stock is only dropped from the “Running List” if it fails the screening process for three consecutive weeks.

2) Your comments that it had only been trading 6 months and had no StockScouter rating raises a suggestion for me. If you think those are reasons to avoid an entry, then my recommendation would be for you to not include stocks that fall into these camps in the list. Because if it’s in the list it makes me think you believe it is a viable candidate for a conservative investor’s consideration.

BCI RESPONSE:
As Alan points out, not having a “StockScouter” rating is not, in itself, a reason to eliminate a stock…there are a lot of stocks that “StockScouter” doesn’t cover (usually American Depository Receipts or ADRs which are foreign companies trading on US exchanges). My comment here was to indicate that you didn’t have as clear a picture of the stock as you might have. Many great candidates have not had “StockScouter” ratings in the past.

Having less than one year of chart history has been a point that the BCI Team has discussed numerous times.  Alan prefers to see a full year of history so the subscriber can see how the stock performs, what happens to the stock after an ER, etc. We ultimately made the decision to include these stocks but add a comment about the less than one year history (located in the key at the top of the “running list”).  Since our subscriber base has a very wide range of risk tolerence, we made the decision to include these stocks, but give a warning. That way, the reader could decide whether to include the stock is a potential candidate for them based on their personal risk profile.

3) The points about day trading and patience I understand. I have always managed my covered call positions by writing OTM on stocks I wanted to keep. I think Alan calls it an overwrite strategy. However, I have believed that in order to get Alan’s 2-4% per month, I thought we had to try and hit “doubles” when the opportunity presented itself so I thought buying back the calls on pullbacks was part of the strategy. Both times I did this I did come pretty close to the bottom of the pullback and the one I resold was at a previous resistance level and the stock was higher than my original purchase price so it seemed like a good place to re-sell it. Having said all this, I would be very interested for more clarification about the “hitting doubles” strategy and why what I did was or wasn’t the right way to execute it or seemed more like day-trading. This seems like something important for me to learn more about.

BCI RESPONSE:
The goal of “hitting a double” is situationally dependent. Per page 259 in Alan’s new book:
“As a rule of thumb, we attempt to hit a double when the market tone and stock technicals are mixed to positive earlier in the contract period (especially during the first week or early in the second).”

What you did made sense. My comment, re: “day trading”, was triggered by the number of trades in the 3/12 to 3/16 time frame. There are times when we have to say that chasing the stock to repair it just doesn’t make sense and exit the trade. There were number of times that you could have exited the trade with either a small loss or a small gain. I’ll try to reconstruct the trade as best I can…I’m not an accountant, so here is my best effort (note the numbers may be slightly off due to the early laddering of strikes)…

2/21 – Opened the trade with a cost basis (C/B) of $17.13
– STO calls…the average premium from the different strikes was $1.70, so
your C/B is now $15.43

3/02 – BTC Mar 17.50 C at $0.36. C/B = $15.79…stock price is $15.26…loss if exit at
this time

3/12 – BTC Mar 15 C at $2.80. C/B = $18.59…stock price is $19.12 (numbers could
be slightly off due to initial laddering of strikes)

NOTE: You could have exited at this time (before the next trade) with a
$0.53 profit (3.1% ROO on initial $17.13 or 2.8% ROO on C/B)

– STO Mar $17.50 C at $0.75. C/B = $17.84

3/16 – BTC Mar $17.50 C at $3.19. C/B = $21.03
– STO Apr 20.00 and Apr 22.50 at avg premium of $1.76. C/B = $19.27
NOTE: Your C/B on 3/12 was $17.84. The stock closed at $20.10 at
expiration. If you didn’t enter the subsequent trades on 3/16 and let
your Mar $17.50 short call be assigned, you could have exited the
trade with a $0.34 loss

4/03 – BTC Apr 22.50 C at $0.20. C/B = $19.47

4/10 – BTC Apr 20.00 C at $0.10. C/B = $19.57

4/18 – Close trade

My numbers are not exact but reasonably close so you can get the sense of the opportunities that were available to make other decisions.

4) Your point about the initial return was too good to be true is thought-provoking. My ITM strike had an ROO of 2.5% and the near-ATM strike’s ROO was 5.3%. What do you think an ATM ROO level is that should raise red flags — anything over 4%?

BCI RESPONSE:
My error…I looked at the $2.50 option value but didn’t realize the call was the Mar $15 ITM call. The return for the ATM call was, as you indicate, 5.25%. In ‘normal” market conditions, Alan looks for 2-4% return. Since the return was 20% higher, it set off a yellow flag in my mind. Remember, with due diligence, it may have turned out that the higher return was justified. The BCI methodology tends to be conservative by design. The higher initial return is another factor to consider…among a lot of factors. Your decision to ladder the strikes was spot on!

The 5.25% ROO, by itself, didn’t raise a red flag…more of a yellow flag that suggested a closer look at the stock. When you look at a complete picture, the factors were:

– The stock didn’t pass the initial screening process…immediate disqualifier
– The stock had less than one year history…not a disqualifier, but a flag indicating
a closer look and a decision based on your risk tolerance
– A initial ROO > 4%…not a disqualifier, but a flag indicating a closer look…the
higher the return, the higher the risk

5) My last comment I put last because it’s about the entry point. Now knowing that the recommendation would have been to avoid an entry on this stock because it was not in the white boxes makes this a moot point. But I did want to get more insights about your comment about the trend and the MACD rollover. If you draw a diagonal resistance line across the top of the candle bodies on 11/22 & 2/7 and then draw a diagonal support line across the bottom of the candle bodies on 12/30 & 3/6, you get a very well defined up-trending channel. My entry on 2/21 was at a bounce off the 50% line within this channel. Here’s my question. Since stock selection and entries are important, I would think that entries on pullbacks are better than entries near tops. So having the price pullback or a MACD rollover as part of a pullback doesn’t seem like a bad entry to me. In fact it seems like a good entry. Thoughts?

BCI RESPONSE:
My comment was based on being put in your position on the day you entered the trade, looking at the chart on that day, and making the trade decision. On 2/21, the price chart indicated that the price had rolled over. When you placed the trade, you, most likely, didn’t know that the price was close to the 20 day EMA. Then, if you looked at the MACD and the Stochastics, they were both below their respective trigger lines…reason to disqualify. Now…looking at the up trending channel you defined…in my personal opinion, it was not confirmed by the technicals…volume, MACD, and Stochastics were showing bearish divergence. Bearish divergence is a flag that there could be an impending change in the stock in the direction of the divergence. While bullish/bearish divergence is, not in itself, a part of the BCI methodology…we try to get a sense of impending changes through the use of the technicals. It is the confluence of all of the data that we generate that gives us a clear idea of what the best course of action should be. However, headline risk is always there, and in this case, it impacted the trade.

Your comment about entry based on pull backs is correct, however, you need confirmation that the pull back is temporary vs. a reversal. Looking at the technicals would have helped you make that distinction. As a side note, INVN appeared in the IBD 50 on the Friday prior to your initial trade. Being on the IBD 50 does not necessarily guarantee that the stock will pass the other screens that are part of the BCI screening process.

SUBSCRIBER EMAIL #3:

Barry,  two things.

1) Excellent answers. I really appreciate your thought process.

2) Thanks so much for spending the time to answer in such detail. I’m sure you have plenty of other things to do so I really appreciate the fact that you took the time to help me.

I’ve re-read your answers a couple of times already and I will do it again because I really want to learn to get good at this.

Thanks again.

BCI RESPONSE EMAIL #3:
… When discussing the trade with Alan, we had one question about the price that you bought back the Mar 15 option on 3/12/12…can you please verify that value?

BCI RESPONSE EMAIL #4:
The reason that I asked you to recheck the value of the BTC Mar 15 on 3/12 is because the option price based on the closing price appeared too low. So, I decided to do a deep dive to see exactly what happened that day using the TOS platform’s “OnDemand” feature to see the trading activity that day. With some help from the support team at TOS, we found out the details of the trade:

– Trading range for the stock that day was $16.75 – $20.10
– Your trade was probably executed sometime between 10:40 and 10:50
– The stock price at the time of your trade was $17.80
So…with hindsight, the price of your trade does, in fact, make complete sense…Stock price @ $17.80, Strike price @ $15, Option price @ $2.80.

SUBSCRIBER EMAIL #4:

Barry, sorry I was slow to get back to you. This was my first opportunity to respond.

First, it’s fine to use this as an example. I think it’s great to have all of us learn from one another.

Second, your detective work was excellent. The 3/12 BTC Mar 15 occurred at 10:34:19 EST. In my trading journal, I record the stock price when I STO the call because I have my journal set up to calculate the ROO. I don’t record the stock price when I BTC since the final return isn’t based on the closing stock price. However, I just went back to the chart and for the minute of 10:34, the stock opened at 17.91, the low was 17.55, and it closed at 17.62. So your assumption of 17.80 is probably very close given it executed 19 seconds into the minute as it was going down.

Conclusion (Alan):

In an effort to educate our members, the BCI team will periodically publish real-life trades like these. Although it is impossible to analzyze every trade sent to us, we will make every effort to publish those that would be most beneficial to our BCI community. Many thanks to Barry for his outstanding contribution to this week’s blog.

Covered Call Glossary:

We’ve added a covered call glossary to our ever-expanding website. Look for the link on the top bar of our site:

Glossary link

June 12th: I will be the keynote speaker for the New York City Private Investors Group at the ING Direct Cafe:

To sign up (seating is limited):

http://www.meetup.com/NYCPrivateInvestors/events/49668332/?a=ea1_grp&rv=ea1&_af_eid=49668332&_af=event

Time: 6PM to 7:30 PM

Admission is FREE and non-members are welcome. 

Market tone:

 This week’s economic reports reflect a sluggish, choppy economic recovery with a bit of long-term concern:

For the week, the S&P 500 declined by 4.3% (ouch!) for a year-to-date return of 3.9%, including dividends.

A comparison chart of the S&P 500 and the VIX shows a technical breakdown of overall market parameters:

• The S&P 500 (green field) drops below the trading range at thew blue arrow
• The VIX (currently @ 25)  breaks out above its trading range at the red arrow
• In the past 3 months the S&P 500 has dropped by 5% and the VIX has increased by 37.5%

Summary:

IBD: Market in correction

BCI: Neutral on US economy but concerned about technical breakdown of overall market and concerns expressed by the Fed. Currently selling only in-the-money strikes and using low-beta stocks or ETFs as underlying securities.

Wishing you the best in investing,

Alan ([email protected])

www.thebluecollarinvestor.com