When it’s time to buy a new car we analyze the reliabilty and safety of the automobile. A comparison is made of the price of the car to the value we are receiving. We contrast that value to the worth of other vehicles. At some point, after all the analysis, a decision is made…..”that’s the car I will buy”. Next we must make another decision…when do we buy? In the summer, the next year models are coming out and dealers want to clear their showrooms, creating great deals for us. Around Christmas, there always seems to be sales and promotions galore. The parameters we use to select a car are different than the ones we use to determine when to purchase.
It is much the same with stocks and covered call writing. We screen stocks fundamentally and technically via the IBD 100, SmartSelect Scan and MSN Scouter. We make sure we have industry diversification and cash allocation equality. Earnings reports and same-store-monthly retail sales reports are avoided as are companies that trade in low daily volume amounts. Ultimately, we create a watchlist of the greatest performing stocks in the greatest performing industries. What’s left? Certainly calculations are critical as are earnings reports dates. But knowing when to buy or sell a stock is so important to our success, just as it is when you purchase your car. That’s where technical analysis comes in.
In our Blue Collar System, we use moving averages, MACD, the Stochastic Oscillator and volume to ascertain the technical health of our equity. For me the moving average is king of these parameters with the others playing confirming roles. Each indicator by itself will not suffice, but as a whole they paint a very important picture relating to our buy-sell decisions. First, some key terminology.
Definitions:
- Moving Average (MA)- the average value of a security’s price over a set period of time. They are used to measure momentum and define areas of possible support and resistance.
- Simple Moving Average (SMA) - a moving average that gives equal weight to each day’s price data.
- Exponential Moving Average (EMA)- similiar to a SMA except more weight is given to the most recent data.
- Support- the price level which a stock has had difficulty falling below. It is a point where a lot of buyers tend to enter the stock.
- Resistance- the price level which a stock has had difficulty rising above. It is a point where sellers tend to outnumber buyers.
- Uptrend- the price movement of a stock is in an upward direction. The stock price forms a series of higher highs and higher lows.
- Downtrend- the price movement of a stock is in a downward direction. The security forms a series of lower highs and lower lows.
- Sideways Trend (consolidation)- the horizontal price movement of an equity where the forces of supply and demand are equal. The stock simply cannot establish an uptrend or a downtrend.
Simple vs. Exponential Moving Averages:
When selling 1-month options, I prefer the ema to the sma because I get a quicker response to a change in the stock price. It also avoids false positives where a stock may jump above the sma but not above the ema. In the chart of AAPL below (taken from www.stockcharts.com), the red line represents the ema and the blue line depicts the sma. Note how the ema starts moving up faster as the stock price appreciates and how the ema would have avoided the false positive in February where the price momentarily breaks through the sma but then drops dramatically:
Simple vs. Exponential Moving Averages
The parameters I like to use ( for covered call writing) are the 20-d and 100-d EMAs. The 20-d approximates the number of trading days in the 1-month contract. The 100-d represents 20 weeks (5 trading days/week) or five months and gives us a longer term perspective to compare with the shorter term 20-d ema. When viewing the moving average indicator, we like to see the 20-d above the 100-d ema and the price bars at or above the 20-d ema. This shows a positive upward momentum and favors (but does not guarantee) continued price appreciation. Moving averages are considered lagging indicators which means they trail the price action of a stock. Thus MAs confirm trends but do not predict them. However, once a trend is identified, we want to be part of that wild ride to cash profits! Here is that same chart of AAPL with the 20-d and 100-d EMAs:
Short Term vs. Long Term EMAs
Notice that at the end of March the short term (20-d in blue) moved above longer term (100-d in red) and then stock went to the moon with the price bars at or above the 20-d ema.
When to use moving averages-practical application:
Moving averages have little value when the stock price is in a period of consolidation. In these instances, we turn to our confirming indicators or exclude the stock from consideration. When the stock is downtrending, we opt for another equity. If the security is trending upwards, the price bars are at or above the 20-d ema and the short term ema is above the longer term ema, this is a strong buy signal. The signal is even stronger if confirmed by MACD, Stochastics and volume. Most winning stocks never make a serious breach of the 20-d ema which is now considered support for the share price. This is indicative of institutional support for that equity. On the other hand, when a stock drops sharply below support on high volume, these major players (mutual funds, banks, insurance companies, pension funds etc.) are starting to move out of this stock and so should we.
Conclusions:
Moving averages are effective tools for identifying and confirming trends as well as support and resistance. This facilitates our trading system as it assists in making our buy-sell decisions. Since it is a lagging indicator, it is not predictive of change as let’s say the MACD is. But as they say on Wall Street, “the trend is your friend” and we want as many friends as possible when investing our hard-earned money. As with all technical tools, moving averages should not be used alone, but rather in conjunction with our other technical indicators.
More information on technical analysis and the confirming indicators are found in Chapter 8 of Cashing in on Covered Calls.
New rules for ticker symbols:
In the past, you could determine which exchange your stock traded on by the number of letters in its ticker symbol. The NY Stock Exchange had 1, 2 or 3-letter tickers, while the Nasdaq-listed had 4 or 5. That has now changed. As of May, 2009, new guidelines were put in place by the SEC, eliminating these requirements. Recently five companies have moved from 3 to 4-letter tickers for branding purposes:
- Pike Electric (PIKE)
- Alexander and Baldwin (ALEX)
- Caci Int’L (CACI)
- Agco Corp (AGCO)
- Comphania Vale Rio Doce (VALE)
The reason the rule was changed was because companies were hesitant to switch exchanges because of the necessity of an ensuing ticker change. This was similiar to when we had to change cellphone numbers when switching carriers. Now this doesn’t influence our investment decisions but when we see a stock with a 2-letter ticker on the Nasdaq exchange we won’t be shocked in disbelief.
Economic News of the Week:
A good week for economic reports. Retail sales rose in May for the first time in three months, business inventories dropped 1.1% in April and the U.S. trade deficit expanded in April. The latter is a good indicator of a recovery, with the U.S. likely to rally before the rest of the world. For the week, the S&P 500 rose 0.7% for a year-to-date return of 6.1%
****June contracts expire next Friday (June 19th) and so we will be planning for the July sales. This means that next week we will be looking for possible expiration Friday exit strategies while paying carefull attention to dates of the upcoming earnings reports. A glance of my watchlist shows that a majority of the July ERs occur after the expiration of the July contracts. Also, keep an eye on NYX, a company that has been unfairly beaten up over the last 18 months but is now starting to recover.
Blue Collar Investors trading on foreign exchanges:
We have a growing population of international Blue Collar Investors some of whom trade on exchanges where the number of shares per options contract differ from our 100 shares per contract. Thanks to Owen Sargent (osargentcpa@aol.com) we have created an international version of the ESOC (calculator) that will allow for these differences. For a FREE copy of the International ESOC, contact me at:
alan@thebluecollarinvestor.com
Videos now showing on the homepage:
1- Selecting the best strike price.
2- Who says we can’t do this?
My best to all,
Alan
What do you think about doing deep in the money, high volatility stocks as a variant to your strategy while seeking similar or higher % returns?
I have done this with Key bank , Etrade and Wells Fargo.
I bought Key at 6 bucks, wrote May 6 for 30 cents with about 2 days left which did not get exercise. Then wrote 5 dollar calls for June on Key at $1.10 and though it was a bit nerve wracking my basis in the stock was 4.45 which was 35 cents below the 52 week low so I felt pretty confident. It recently went to 6 bucks a share although it did go down to around 4.70 at one point.
On etrade I wrote 1 dollar calls for July when the stock was around 1.50, lowering my basis to 88 cents which looks really safe now.
I particularly like doing this after the stock has dropped some on bad news. Looking on the internet, I saw that someone else had this same idea.
Thanks,
Karl
Karl,
Those who have been following my posts the last several months know that I LOVE I-T-M strikes in the current market environment. The option buyer is paying for OUR insurance and decreasing our risk…thanks guys! The deeper I-T-M we go, the lower our profit so make sure you are gaining an acceptable ROO before doing the deal.
As far as stocks with high volatility, they will bring a higher option return. It depends on your risk tolerance. If the fundamentals and technicals are perfect and you sell an I-T-M strike, I’m on board.
Thanks for sharing your strategy and experiences.
Alan
Hi Alan,
I liked your book on exit strategies but many of the examples showed that you bought a stock far below its simple 20 day moving average.
For example BLUD, Fig 15…The 20 day moving average is quite higher than the stock but you intimate that the techinical pattern is good.
Maybe you are showing a shorter time frame but perhaps a 3 month chart showed a better technical pattern.
What time fram do you look in evaluating what a stcok might do over 1 month. I have been looking at 3 month charts.
thanks
Evan
Evan,
The 1-month charts shown in my most recent book on exit strategies were used to show the correlation between the stock price and the option value. A 1-month chart is NOT adequate for technical analysis of an equity to determine if it should be placfed on our watchlist. Also, this book was written in 2008 when ALL stocks were down in value. I prefer at least a 6-month chart so I can get a perspective as to what that equity has done in the past when (for example) it dips slightly below its 20-d ema. Chapter 8 in my first book, Cashing in on Covered Calls, goes into detail as to how I evaluate an equity technically for covered call consideration.
Bottom line….1-month charts are not adequate for technical evaluation of an equity. The 3-month chart you are using is better. Many investors prefer a 6-month to a 1-year chart. This way we can compare the current month’s price pattern to past history
Alan
Hi Alan,
For the last couple of weeks I have been unable to view the videos on the homepage. I get a message that says an error has occurred and to please try again later. Is there a problem with the website?
Thanks
Jack
Alan,
Something for the BCI Team to consider…look at the 5 day EMA. It will show the current trend in detail…but…still make our decisions based on the 20 and 100 day EMAs.
I ran all of the IBD100 today through my, somewhat more conservative, filters. Here are the candidates:
FUQI
VPRT
GMCR
STAR
NTES
SYNA
AZZ
TSRA
MIDD
CPSI
GR
CERN
RHT
CRI
AAN
WBSN
BJRI
LXU
HDB
VSAT
CXO
The best,
Barry
To Barry:
Thanks for sharing your ideas and due-diligence.
To Jack:
The videos are playing fine on both my computers and the ones in my office. It plays on both AOL and Internet Explorer. If anyone else is having this problem or has a suggestion for Jack, please let me know.
In the interim, here is the YouTube link to the current video:
http://www.youtube.com/watch?v=o45p31pAloM
Alan
I noticed that two of the stocks on the outstanding list that Barry suggested in comment #6 were not on my watchlist. These were :
AZZ
VSAT
In the past both were on my watchlist but were bumped due to low trading volume. This represents potential volatility in these equities. Now this does NOT mean that they are not great cc candidates, simply that they may be more volatile than other candidates. Everything depends on your personal risk tolerance.
I eliminate all stocks that have a lower trading volume than 250,000 shares/day. This information can be obtained from the Yahoo finance quote page:
http://finance.yahoo.com/
Then type in the ticker and look for the average volume in the middle of the quote page.
Trading volume is also found on the charts adjacent to the IBD 100 list.
Alan
With Expiration Friday only 3 days away, it’s time to start thinking about possible Exp. Friday exit strategies. We check to see which equities are trading above the strikes sold. For example, I sold the I-T-M $45 June call for URS. The stock is currently trading @ $47.71. If we were to roll out today (I usually wait until thursday or Friday, but nothing wrong with today), here are the calculations:
Buy-to-close June $45 call @ $2.90
Sell July $45 call @ $4.00
ROO = 400 – 290/4500 = 2.4% = 29% annualized
Downside protection = 271/4500 = 6%
This means we are guaranteed a 2.4% 1-month return as long as our shares do not depreciate by more than 6% in the next month.
We then compare these returns with others that our $4500/contract will generate. If we still like URS, this would be an acceptable return with great protection.
Alan
This Friday is Quadruple Witching Friday! Sounds scary, doesn’t it? Here is a link to an article I previously published regarding how this impacts our investment positions:
http://www.thebluecollarinvestor.com/blog/triple-witching-friday-coming-to-your-portfolio-on-march-20th-plus-industry-in-the-spotlight/
Alan
TRLG- goodbye for now:
One of my portfolio stocks, TRLG has broken down technically. I sold the June $20 (I-T-M) call and the stock, although down in value, is still above the strike price (at the time of this post, $20.27).
If the share price is still above $20 tomorrow by 4PM, I will elect NOT to execute an expiration Friday exit strategy because of the deteriorating chart pattern. The stock will automatically be sold over the weekend.
You may want to build the chart @ http://www.stockcharts.com as set forth on page 85 of “Cashing in on Covered Calls”. Take a look at the MA, MACD and Stochastic Oscillator and see if you agree that staying with this one is way too risky. Should the chart pattern improve, I may let it back in…after all, it did make good money for me this month.
Alan
Hello Alan,
Re: TRLG…
I took a look at the chart and I agree with you…its’ not pretty. Specifically:
[1] The price is down trending sharply
[2] The price is below the 5 day EMA (my tweek)
[3] The price is below the 20 day EMA
[4] The MACD is below the signal line and down trending
[5] The MACD histogram in negative for the last 9 days and no sign of a direction change
[6] The Stochastics are below the signal line and below 20…the oversold line
[7] The RSI (my tweek) is below 50 and down trending
So…it seems that TRLG is violating every technical guide post that the BCI system uses and should, as you said, be let go after expiration.
Barry
Re TRLG:
An alternative view. While this stock is violating some technical issues, it seems to be finding support at the 50 day MA, where institutional investors tend to buy good stocks. The stock has had a huge run up and it may just be taking a break through a healthy correction. It is premature to enter a new CC trade but I have added it to my watch list. I will see if it continues to stay above the 50 day MA.
Jay
Thanks to Barry and Jay for their astute comments. Two more points I’d like to add:
1- Longer term investors, like the institutional investors that Jay alluded to, more commonly use the 50-d and 200-d moving averages for their buy-sell decisions. These are the MAs I employed when I was simply buying and selling stock, before selling options became my main strategy.
2- When an equity breaks down technically after being strong for a while, I bump it from my portfolio of stocks that I currently purchase BUT LEAVE IT ON MY WATCHLIST FOR AT LEAST A FEW MORE WEEKS. If the technical picture changes , I may again use that security in the near future. If it continues to break down, it gets bumped from my watchlist as well and will then have to earn its way back on.
Alan
Hi Alan, I took a look at the chart for VPRT. The trend is positive with stock price above the 20d ema, and the 20d ema above the 100d ema.However, the other indicators confuse me. The MACD is oscillating above and below 0. The slow STO is oscillating above and below the 80% line.Can you offer any insight here? Thx, Dave
Dave,
Excellent observation and why I always say that technical analysis is a much an art as it is a science. Here is one man’s interpretation:
We have absolutely identified an uptrend meaning strong institutional support. The MACD can’t make up its mind but the stochastic oscillator has turned negative. We have a mixed technical picture. Note, however, that the negative changes occured on weaker volume making these changes less significant.
I would still have the same concerns you do and opt for selling I-T-M strikes on this one but not dump the stock if the fundamentals and calculations are still favorable.
I welcome other interpretations.
Alan
Dave,
Try looking at support for VPRT…and if the strike just below support has a decent premium, it might be a good call to write. This is in keeping with Alan’s comment about ITM calls with mixed technicals.
Barry
10% in 1 month!
I just found a stock that has an option premium which generates 10% in one month. That’s great isn’t it? Well, maybe not. We’ll discuss this and much more PLUS a brand new video will play on the homepage in my upcoming journal article to be published this weekend.
Alan