Let’s set up an example as to how this works. Let’s assume that during the past 14 trading days stock XYZ has seen a low of $30 and a high of $40. Today it closed at $38. Within the $10 trading range, the stock is $8 up or in the 80%. If the stock closed today at $32, it would be at the 20%. This is known as %K in stochastic lingo. Transaction signals occur when %K crosses its 3-day simple moving average called %D. This is also known as the trigger line. Let’s look at a chart that shows the stochastic oscillator: 

Stochastic Oscillator Chart- Slow

Note the following:

• Stochastic oscillator = thick black line highlighted by the black arrow = %K
• Trigger line = red line highlighted by red arrow = %D
• Overbought (80%) and oversold (20%) levels are highlighted by the green circles. 

Some chartists use crossovers of %K and %D as buy/sell signals. However, these signals occur quite frequently and can result in whipsaws or a myriad of short term signals. A more reliable reading (in my view) is when the oscillator moves from overbought (above 80%) to below that level or from below oversold (20%) to above that level. A strong stochastic signal occurs when the positive divergence above 20% or a negative divergence below 80% takes place for a second time or a double dip. Here are the guidelines:

Buy signal: %K crosses above the 20% for the second time

Sell signal: %K moves below the 80% for the second time.

In the chart below, we see a clear buy signal highlighted by the green circle and the price then accelerating as seen by the green arrow. There is also a definite sell signal highlighted by the red arrow with the subsequent price decline shown by the red arrow.

Stochastic Oscillator- Buy and sell signals

Slow versus Fast Stochastics: 

One of the problems with %K in relation to %D is the high number of false breaks, whipsaws and crossovers. To mitigate this issue, the slow stochastic oscillator was developed. This is derived by applying a 3-day simple moving average to the %K thereby smoothing the data to form a slower version of %K. An equation that can be used to visualize this would be: 

%K (slow) = %D (fast) 

Then to form a trigger line for this slower version, a 3-d SMA is created and applied to the new %K (slow). 

When building a chart, there is usually a choice of selecting slow or fast stochastics. I always opt for the slow stochastic oscillator as it is easier to read and interpret and eliminates many of the false triggers inherent with the fast oscillator.

Full Stochastic Oscillator: 

There is actually a third stochastic oscillator called full stochastics. Rather than being required to use the 3-day SMA of the %K as in the slow stochastics, traders felt that this should be a variable so more flexibility could be achieved. A third variable was created called the smoothing variable which alters the amount of days used in the smoothing of %K. One can also recreate the fast and slow stochastics by the full stochastic. To mimic the fast stochastic, use a 1-day smoothing number. To mimic the slow stochastic oscillator, use a 3-day smoothing number. 

Conclusion: 

For purposes of 1-month covered call writing, I have found the slow stochastic oscillator most useful and time efficient. It is a widely used momentum indicator that measures who is winning the daily battle between the bulls and the bears. As always, it is prudent to use this oscillator in conjunction with our other technical indicators. See chapter 8 of Cashing in on Covered Calls  for a review of all technical indicators used in the BCI system.

Event update: 

1- I will be hosting, along with Barry Bergman, a BCI team member, a seminar on Long Island on August 12th @ 7PM titled “A Practical Approach to Covered Call Writing”. We will be using real life examples to set up a covered call portfolio. We will incorporate audience participation while setting up a current portfolio. The investment club that invited me to speak charges NO ADMISSION FEE and does not require club membership to attend. Here is the location information:

Plainview-Old Bethpage Public Library

999 Old Country Rd
Plainview, NY 11803
516-938-0077

2- Thanks for all the inquiries about my third book. It is a huge undertaking (twice as many charts, graphs and figures as my first two books) but I feel that I am still on track to have it published by the end of the year. My team and I are also working on additional educational projects based on your feedback and requests. Also, phone coaching will soon be available. Premium members will continue to receive discounted pricing on all products and services.

Market tone:

Like last week, the reports this week were generally negative. Exisitng home sales and new home starts were both down because of the culmination of the federal homebuyer tax credit. The Conference Board’s index of leading economic indicators was also down 0.2% in June but still up 2.6% for the year. Economists at the Conference Board described the economy as expanding but at a slow pace…we’ll take it! For the week, the S&P 500 rose by 3.5% predominantly due to a host of positive earnings reports and the encouraging results of the European Bank stress tests. Those of us who have invested in the market all year know that stocks were behaving well through mid-April and then took a nose dive until recovery set in by early June. Let’s first look at a 3-month chart of the VIX which has an inverse relationship with the S&P 500. Conservative investors prefer the VIX to be descending or below 30; below 20 is even better:

The VIX as of 7-23-10

The red arrows show a calming of investor sentiment earlier in the year and most recently while the green arrow shows when all _______broke lose and we needed to reach into our bag of exit strategies to combat the forces of evil. This is confirmed by a 3-month chart of the S&P 500:

S&P 500 as of 7-23-10

These whipsaws in the VIX and S&P 500 are not friends of conservative covered call writers. It will enhance our option premiums but also exacerbate risk. The reason I remain cautiously bullish is because of the (slowly) expanding economy and my sense that earnings will continue to impress.

Summary:

IBD: Market in a confirmed uptrend.

BCI: Cautiously bullish. I am currently fully invested selling predominently I-T-M strikes.

The best in investing to all,

Alan (alan@thebluecollarinvestor.com)

LULU- Chart as of 7-16-10

• The red circle highlights a recently ascending price pattern but still slightly below the 20-d ema, a negative.
• The red arrow shows the MACD histogram just turning positive, a bullish signal.
• The blue arrow highlights the stochastic oscillator moving above the 20% and ascending, also a bullish signal.

Since this is a mixed technical picture, (should I decide to keep this equity) I would lean to the rolling out strategy wherein we start the contract cycle with an I-T-M strike and downside protection. I will, however, also compute the rolling out and slightly up strike as well. We must first ensure that this equity is NOT reporting earnings in the August cycle. NOTE TO PREMIUM MEMBERS: The ER dates we provide in our reports should be rechecked prior to trade execution because corporations may change a date last mminute in rare circumstances. Here is the projection from www.earningswhispers.com:

LULU- Earnings report

The scheduled report date is 9/9/10 (highlighted in yellow) well after the end of the August expiration which is 8/20/10.

Next we will run our calculations with information obtained from the July and August option chains. We first check the July chain to see what it would cost to buy back the short option position we originally sold (B-T-C). Please note that this article was written mid-day on Friday:

LULU: B-T-C July contracts

I have highlighted the July contract in yellow and circled (in red) the cost to B-T-C, $1.05. It is possible we could have reduced this price by playing the bid-ask spread. Next we look at the August chain to see the cash amount that will be generated from selling the August $38 or $39 contracts:

LULU: S-T-O August contracts

We will receive $2.60 to roll out to the $38 call and $2.25 to roll out and slightly up to the $39 call. Once again, the large bid-ask spreads may allow us to generate even more cash. Because of the mixed technical picture, I will generally lean to the I-T-M strikes. This information is then fed into the “What Now” tab of the Ellman Calculator as seen below:

Ellman calculator- enter info

Note the entries of $1.05 (red arrow), $2.60 (blue arrow), and $2.25 (green arrow). Once entered, the calculations will appear on the right page of this tab:

LULU- Rolling calculations

• Highlighted in yellow is the 4.08%, 1-month return for rolling out.
• The red arrow shows a downside protection of $88 per contract
• The green highlighted area shows rolling out and up returns both with (5.79%) and without (5.47%) upside appreciation.

Conclusion:

When considering expiration Friday exit strategies we must first check the stock’s fundamentals and technicals. If technicals are mixed we may want to garner the extra protection of an I-T-M strike by rolling out and NOT out and up. Consideration should also be given to general market tone. We must also make sure that there is no earnings report due in the upcoming cycle. Finally, the calculations must meet our goals which for me are 2%-4% per month. Once these positions are established, they must be monitored as any other covered call position.

Market influence on mid-contract exit strategies:

Most covered call writers are conservative investors who do not appreciate market volatility. We can still generate fabulous returns in normal market conditions. When we have dramatic whipsaws in the market, opportunities are created to enhance our returns or at least minimize losses. This month many of us hit several doubles or perhaps rolled down. The 1-month chart pattern of the market benchmark for the past cycle highlights the type of market pattern that offers these opportunities:

Exit strategies and the S&P 500

The past contract cycle opened and closed at the red lines. The green arrow shows a severe dip when we have a chance to buy back our options (using the 20%/10% guidelines) at a greatly reduced price. We then are prepared to resell our options should the market recover which it did as shown by the blue arrow. Whether we rolled down or “hit a double” this is cash we would have not generated had we not been prepared to execute an exit strategy. THIS IS NOT LUCK; but rather the intersection of preparation and opportunity.

Market tone:

The economic reports this week leaned more to the negative which may account for the dramatic dip in stock prices on Friday. Consumer spending declined by 0.5% in June, the U.S. trade gap rose in May to the highest level in a year and a half, factory orders rose at a slower rate than expected and the Federal Open Market Committee (FOMC) downgraded its expectations to a slower recovery than previously anticipated. For the week, the S&P 500 declined by 3.5% (including dividends). A 3-month chart shows a downward trend:

3-month chart of S&P 500 7-16-10

This is confirmed by a 6-month chart which displays a series of lower highs (red arrows) and lower lows (green arrows):

Market trend 7-16-10

Summary:  

IBD: Market in confirmed uptrend (this is a longer term outlook).

BCI: Cautiously bullish, favoring I-T-M strikes as this site is anticipating encouraging earnings reports over the next several weeks.

My best to all,

Alan (alan@thebluecollarinvestor.com)

What if the market or equity technicals are volatile or slightly bearish? Should we not consider the protection afforded by in-the-money strikes? The risk is that the stock will head north and we will miss out on the appreciation. The benefit is that the option buyer is purchasing insurance for us in the amount of intrinsic value of the option premium. This generosity should be given consideration when market or stock indicators dictate. Furthermore, in-the-money strikes have deltas approaching “1″. This means that as the stock moves up or down, the option value will move up or down in a similar amount. If the stock starts declining in value, so will the option premium and it will be less costly for us to buy back (B-T-C) the option to execute an exit strategy.

Once we have selected a stock for our portfolio, we can run the calculation for the different strike prices using the “single tab” page of the Ellman Calculator (ESOC). This tab allows you to view up to four different strike prices for the same equity. 

Procedure: 

Simply input the information required into the blue cells on the left side of the single tab page as shown in the figure below. All of these figures are gleaned from the option chain:

Ellman Calculator- Single Tab- enter info

 SNDK is currently trading at $46.62 with three weeks remaining until expiration Friday. We will look at the in-the-money $45 strike, the near-the-money $47 strike and the out-of-the-money $50 strike. 

Information Generated: 

For each strike price submitted, the calculator specifies ROO (return on option), upside potential, downside protection, share buy down (I-T-M strikes), proceeds, cost basis and annualized returns. All of this information appears in a split second and can be printed to facilitate the best possible investment decisions. The chart below shows these results for SNDK:

Ellman Calculator- Single- Final calculations

• Only the I-T-M strike ($45) offers downside protection as seen in the cell highlighted in yellow.
•  The cells highlighted in green show the actual return on the option when initially sold.  
• The cells highlighted in blue show upside potential if shares appreciate in value. 
• The cells highlighted in red show maximum possible profit percentage for each strike price.

Depending on your market outlook, risk tolerance and stock technicals, you can use this information to select the strike price that best meets your needs.

The Elite Calculator:

For the past several months, the BCI Team has been working hard developing an enhancement to the basic Ellman Calculator. It now complete as I am in the process of writing a user guide and my webmaster is adding the tool to the website store. The Elite Calculator will have two additional sections. One is the “unwind tab” which allows you to calculate returns mid-contract and a Schedule D which will shows long term and short term capital gains (losses). Those trading outside sheltered accounts will greatly benefit from this added link. Below is a “sneak preview” of the information page of the Schedule D where I highlighted (in yellow) the six different investment choices this tool offers:

Schedule D- Information page

Currently premium members have access to the “unwind now” tab in the resource/download section of the premium site. The completed Elite Calculator will be uploaded once I have completed the user guide and will be FREE to all premium members.

Event update: 

1- I will be hosting, along with Barry Bergman, a BCI team member, a seminar on Long Island on August 12th titled “A Practical Approach to Covered Call Writing”. We will be using real life examples to set up a covered call portfolio. More information will follow.

2- I have completed the first rough draft of my third book. It incorporates information from my first two books, new updated information and material from three years worth of journal articles I have written. I will go through the book at least ten more times before handing it over to my publisher. My goal is to have it published by the end of the year.

Market tone:

The news this week was more negative than positive. For the first time this year, the number of employed workers fell as did consumer confidence, construction spending, manufacturing growth and factory orders. On a positive note, the unemployment rate fell slightly to 9.5% and personal income, savings and spending rose. For the week, the S&P 500 fell 5% (ouch!) for a year-to-date return of (-) 7.4%. Below is a comparison chart of the S&P 500 and the VIX (CBOE Volatility Index):

S&P 500 vs. the VIXD 7-3-10

The red arrow shows a declining S&P 500 and the green arrow shows a declining VIX after a major advance. The S&P 500 did beak through support (about 1045) this week but on unimpressive volume. This is still a technical negative.

Summary:

IBD: Market in correction.

BCI: Neutral and taking a defensive posture. Market fundamentals remain predominantly positive showing a slow but continuing recovery. My expectation is that earnings next month will be favorable. However, the market volatility and technical breakdown will lead me to favor I-T-M strikes. I bought back 30 contracts on Thursday and Friday and will roll down or unwind if there is no turnaround on Tuesday or Wednesday.

Where’s Alan?

My son Jared is getting married this coming weekend and I will fall behind in my email responses to you. I will publish next week’s article early and catch up the following week. Premium members will see NO DELAY in publication of the ETF and premium reports.

Best regards,

Alan (alan@thebluecollarinvestor.com)

Let’s assume we have gone through the process of stock selection or referenced our premium report. The number of stocks to include in this months portfolio would depend on the amount of cash we have to invest:

$50k or less = 5 to 6 stocks

$100k or less = 5-10 stocks

$250k or less = 10-15 stocks

Once we have ascertained the number of different stocks to include in our portfolios, every effort is made to invest a similar cash amount into each equity. In this article’s hypothetical, we have nine stocks and $100k to invest:

Cash Allocation Chart

With nine stocks and $100k, we approximate $11k per stock. Next we divide the price per share into $11k and get the number of shares we can purchase. Since 1 options contract = 100 shares, we must round off to the nearest one hundred. If the number is near the middle as it is with FFIV, I will round up or down based on previous experience with that security.

Next I will multiply the number of rounded off shares by the price per share and calculate the total cost to purchase all shares. In the above chart, that comes to $96,780. I do this for two reasons. First I want to make sure that I can pay for all these shares and don’t go over my $100k budget. Second, I want to be sure that I also have extra cash left over for possible exit strategy execution. In the above example, $3220 is the cash balance, quite adequate. We take this information together with the calculations computed by the Ellman Calculator and sit down in front of our computer and start generating cash!

Note also that with the exception of XEC, we sell more than one contract for each stock. That will allow us to “ladder” our strikes if we so choose. In other words, for an equity like PAY we can sell three O-T-M strikes and two I-T-M strikes or some other combination depending on our market outlook. If we were extremely bullish on the market and stock technicals were impressive and confirming, we may opt for five O-T-M contracts.

Market Tone:

The Federal Open market Committee (FOMC) said that economic recovery was continuing and that the labor market was “improving gradually.” However, it voted to keep the federal fund’s rate between 0% and 0.25% “for an extended period.” This was the result of high unemployment, lower housing wealth, tight credit and modest income growth. For the week, the S&P 500 declined by 3.6% for a year-to-date return of 2.5%.

This week I constructed a 1-year chart of the S&P 500 using longer term 50-d and 200-d simple moving averages. This will allow us to factor in certain support and resistance levels as we make our investment decisions:

S&P 500 as of 6-26-10

• Blue arrow- The S&P 500 broke below its 50-d sma 
• Red arrow- The S&P 500 broke below its 200-d sma
• Green line- The 200-d sma is serving as short-term resistance
• Purple line- Long term support is at the 1050 level

The S&P 500 recently bounced off resistance and is heading back to the support level. If it breaks support with high volume I would consider this a bearish signal and give serious consideration to decreasing my positions in the market. On the other hand should we break resistance on high volume we would have a bullish signal and perhaps enhance our O-T-M positions.

Summary:

IBD: Uptrend under pressure

BCI: Cautiously bullish. Fully invested in the cc portfolio with a higher percentage of I-T-M strikes sold.

My best to all,

Alan (alan@thebluecollarinvestor.com)

A gap is a break between prices on a chart that occurs when the price of a stock makes a sharp move up or down with no trading occurring in between. Gaps can be created by factors such as regular buying or selling pressure, earnings announcements, and changes in an analyst’s outlook or any other type of news release. Here is a chart of BCSI which gapped down after an earnings report disappointed:

                      Figure 1-Gapping down 

From $29 per share this stock gapped down to $22 per share. Now for those Blue Collar Investors who follow my system you would not have been hurt by this precipitous drop because we avoid earnings reports for this very reason. However, a stock can gap down for some of the other reasons just mentioned. If there are many more sellers than buyers, a stock will gap down. A stock gaps in price when a blank space is left on the chart where no trading occurred.  A gap up is when the current bar’s low is above the previous day’s high.  A gap down is when the current bar’s high is below the previous day’s low.  Stock gaps occur as a result of excessive buy or sell orders which forces prices either up or down.

How to manage a stock that has gapped down:

When a stock gaps down, human nature is such that you want to get your money back with this same equity. In this way, it will no longer be perceived as a loss. As a result, many investors will not unwind their position and just ride it to wherever it goes. This approach is misguided is some instances. Think back to stocks like Enron, Tyco, WorldCom, Citi, Bear Stearns, Lehman and many others. Holding positions in these companies spelled disaster even though these corporations were considered pillars of our economy at one time. Circumstances change and so we must be willing to change our perspectives as well. When a stock drops from $29 to $22 as it did in figure 1 above, we now have $2200 in cash per contract. We no longer have $2900 per contract. That was yesterday, not today.  The question becomes “where do we want this cash to be placed to give us the best chance for a successful investment?’ It may or may not be with this same security. So step one is to determine what caused the gap down. We must check the news to see what caused this unexpected turn of events. If it is a serious matter like corporate fraud, a key member of the Board of Directors leaving the company, the loss of a patent, the FDA disapproving a new drug, new legislation that negatively impacts that company or other events that dramatically alter the prospects for that company, it is time to hand that cash over to a new financial warrior. If, on the other hand, it dropped in price due to a less serious matter like a single analyst downgrade or guidance being amended slightly and a market over-reaction followed, we may opt to stay with the same equity.

Let me give you an analogy for those of you familiar with casino blackjack. In this hypothetical you hold a “15” and your prospects look bleak. This is analogous to the stock after it has gapped down. The dealers hand represents the circumstances that will dictate how to manage the gap-down. Now do you stay with the “15” or do you make a change? Well that depends on the cause of the event or the dealers hand. If the dealer has a “5”, the event was not a serious one and the corporation remains a great opportunity in your eyes. Therefore you hold your position as there is a good chance the dealer will “go bust” or go over “21” with his next card. Your investment outlook by holding your position looks positive. If, however, the dealer is sitting with a “10”, the cause of the gap down was a serious blow to the stock and holding would be a poor decision as the dealer has great prospects of having a “20” and destroy your prospects of a successful investment. Therefore, we must change financial soldiers and take another card. The point here is that given the same hand but different conditions, we must make different decisions. In much the same way, once we determine the cause of the gap down, we must have the non-emotional flexibility to make a change if that approach is indicated.

You decide to keep the stock:

If your decision is that the cause of the gap-down was not serious and you still have a great opportunity with the same equity, we first buy back the option. Since the price has declined dramatically, the price of the option has also done so. If we are mid-contract or earlier, I will wait for a bounce back and resell the same strike to hit a double. If the stock is slow to recover, we can roll down to a lower strike price that is still above the current market value. In the example above, selling the $22.50 strike will generate income to help offset the share value depreciation. If we are correct and the stock continuers to recover, we can nurture this security up by selling out-of-the-money strikes.

When we decide to hold a stock that has gapped down, we are employing a strategy I have named technical nullification. In a manner similar to jury nullification, where a jury ignores the facts and opts for an atypical conclusion, we will be ignoring the technicals like the chart pattern and accumulation/distribution (A/D) and others and still hold this equity. Let’s look at a chart of BCSI three weeks after the gap-down where it is consolidating and forming a base from which it may head back north:

BCSI after gap-down 

Notice how BCSI after the huge gap-down (red arrow) has been trading sideways between $22 and $23.50. Using technical nullification and feeling the prospects of a return to previous pricing will lead us to selling O-T-M calls, in this case the $25 strike. The option chain shows a return of near 2% for the next month out-of-the-money $25 call:

BCSI- option chain 

In addition to looking at the short term technicals of the stock after the gap down, we should also compare its price performance to that of the broad market. If it is consolidating (trading sideways) but well-underperforming the general market, I would view that as a negative and consider selling the stock. In the chart below, we see however, that BCSI has equaled the recent price performance of the S&P 500, re-enforcing the confidence we may have in this equity.

You decide to sell the stock:

If you feel that the cause of the gap down was a longer term issue, buy back the option and sell the stock. We then utilize the cash generated from this sale to enter a new covered call position.

Both management decisions can be re-evaluated as time progresses using the same exit strategy maneuvers discussed in my books, Cashing in on Covered Calls and Exit Strategies for Covered Call Writing.

Conclusion: After a stock gaps down as a result of an unusual event we have the choices of either unwinding our position or keeping the stock. We base our decision on the reason for the gap-down. Should we consider keeping the stock, it will require technical nullification, monitoring the technical pattern of the stock after the gap-down and comparing the price action to that of the broad market.

Market tone:

Economic reports continue to point to a slow but palpable recovery. Consumer and producer prices fell, allaying fears of inflation. The Conference Board reported continued expansion of our economy. Although housing starts slipped, factory orders continued to surge. For the week, the S&P 500 rose 2.4% for a year-to-date return of 1.2%.

Looking at a 3-month chart of the S&P 500 and the VIX (CBOE Volatility Index) we see a sideways trading stock market (red line) with a huge drop in volatility (green arrow):

S&P 500 vs. the VIX 6-18-10

Summary:

IBD: Market in confirmed uptrend.

BCI: Cautiously bullish. With the volatility significantly reduced and the economic stats pointing to a continued recovery, this site continues to believe that corporations will show improving profits leading to higher stock prices. There remains trillions of dollars on the sidelines that can pump up the stock market as investors gain confidence. We continue to have concern about the unemployment issues, the debt crisis in Europe and the housing recovery. My plan for this month is to convert my ETF positions to individual equities favoring the stocks in bold on the premium watch list.

The best in investing,

Alan (alan@thebluecollarinvestor.com)