Chapter 8 in Cashing in on Covered Calls is devoted to technical analysis. This is a method of predicting future stock price movements based on observation of historical stock price movements. We use it to identify trends and for our buy/sell decisions. The parameters I chose for my system include moving averages, MACD, stochastics and volume. These indicators paint a picture that allow us to enhance our investment decisions.
Another set of tools available to the technical analyst are the numerous theories regarding market activity. They, too, reference historical patterns in the market that may signal a bullish or bearish sentiment. The purpose of this article is to present an overview of some of these theories and the rationale behind them.
The Short Interest Theory:
This theory states that a larger short interest is the predecessor of an increase in the price of a stock.
A short sale is the sale of a stock not owned by the seller. It is borrowed from the broker and eventually must be replaced. The seller anticipates a decline in equity value and realizes a profit by covering (buying back) the short sale at a lower price in the future.
Short interest is the number of shares sold short that have yet to be covered. Shares ultimately will need to be purchased. Also, some short sellers fearing an increase in stock price, may cover their positions sooner than anticipated. This is called a short squeeze. A rising short interest is considered a bullish indicator.
Odd Lot Theory:
This is the ultimate insult to everyone in our group! This theory is based on the assumption that the small investor is always wrong (bring it on!). Since these investors usually buy and sell in odd-lot amounts (less than 100 shares) and have low risk-tolerance (the theory continues), they tend to buy high and sell low. A bullish signal is when odd-lot sell orders increase relative to odd-lot buy orders.
The Advance-Decline Theory:
Also called the Breadth of Market Theory, this theory states that the market direction can be determined by the number of stocks that have increased compared to those that have decreased in value. It is considered bullish if more shares are advancing than declining.
The Dow Theory:
This theory states that the market is in an upward trend if one of the averages (industrial or transportation) advances above a previous significant high and is accompanied by a similar advance in the other. A major trend is identified only when BOTH the Dow Industrial and Dow Transportation Averages reach a new high or a new low. Without this confirmation, the market will return to its previous trading pattern.
Free sites to locate information:
1- Odd-Lot and Advance-Decline:
http://www.wallstreetcourier.com/index1.htm
Click on “chart” to get a visual representation.
2- Advance-Decline:
http://finance.yahoo.com/advances
3- Short interest:
http://online.wsj.com/mdc/public/page/2_3062-nyseshort-highlites.html
4- Dow Industrial Average:
http://money.cnn.com/data/markets/dow/
5- Dow Transportation Average:
http://money.cnn.com/data/markets/dowtrans/
Industry in the Spotlight:
Who says that there is a recession? One of the best performing industries over the past few months is the Casino and Gaming Group. I recently had family gatherings in Atlantic City as well as in Las Vegas and I can attest to the fact that the gamblers are out in full force. That’s not to say that this group didn’t take a big hit during the heart of the recession, but it appears to be recovering very nicely of late. The industry ranks in the top 10% of new institutional money flowing into its group’s equities. Here is a current chart of this industry:
Casino and Gaming Industry as of 8-7-09
Note how we have identified a trend which is confirmed by all supporting indicators. The top-performing security within this industry is WMS. Here is the current chart of that stock:
WMS as of 8-7-09
They say a picture is worth a thousand words! Another good performer in this industry is ASCA.
Last Week’s Economic News:
Although service-sector business activity, personal income and real consumer spending declined, there were some positive reports. The manufacturing index as published by the Institute of Supply Management (ISM) increased for the seventh straight month. Also, the jobless rate in July dropped to 9.4% from 9.5% in June, the first decline since April of 2008. For the week, The S&P 500 rose by 2.3% for a year-to-date return of 13.6%.
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Alan ([email protected])
Offsite email question:
Regarding to rolling out and up options:
In case the price of the stock is above the strike price + the premium we received from the original sell ( for example in week 1)
Isn’t it better to buy it back instead of letting it go up for example in 20% before expiration Friday?
I’m talking about a stock you intend to keep more then a year.
please let me know your thoughts
Thanks
MY RESPONSE:
In a situation when you are rolling out and up, the stock has either appreciated above the strike or remained above the strike if you originally sold an I-T-M strike. If you buy back the option early in the contract period, you are “buying up” the value of your stock from the strike to the current market value but you are also paying additional cash for the time value. We are, in essence, negating the advantage of being a covered call SELLER. The premium we generated from the original option sale is money in the bank and now we move on to the next deal. Why give back our profit and then some?
Come expiration Friday (or near), it’s another story. Time value has eroded to near zero. We may buy back the option and sell the next month premium, thereby creating another PROFIT. Time value of the option premium is now on our side for the next month and the current one.
Also, in my system, there is no such thing as a stock you intend to keep for more than a year (ETFs could be another story). This is because I do not sell covered calls on stocks reporting earnings in that particular contract period. Perhaps you haven’t read my first book, “Cashing in on Covered Calls”. Since most companies report every 3 months, the longest time frame I stay with an equity is 2 months. You can then jump back in after the ER.
Alan
Offsite follow-up question to comment # 1 above from G:
Regarding my question:
I will give you more info :
The original strike is OTM
I’m choosing an OTM strike price with probability of 80% (using investools probability calculator) to be below at expiration date.
Wouldn’t it be smarter to buy back at strike + premium (on week 1,2) and roll it up to higher strike, despite the extra time value you pay, rather then wait until the last Friday when the price can be up more, and you will need to pay more for rolling it.
I’m asking this because it is critical for me to know which will do better . My purpose is when the stock appreciates to be able to hold as long as I can for the appreciation.
I’m planing to hold an ETF – symbol TLT ( long term bonds 20+ years) for more then a year.
Best Regards,
G
My response:
G,
Regarding your question about rolling up: I feel that it is important to have a system that you are confident in. You have selected an ETF and strike based on the fact that you like the security and feel that there is an 80% probability it will close lower than the O-T-M strike. It seems that once the price goes above the strike, you are looking to abandon that conclusion. You will succeed if the price continues to appreciate more than the loss incurred from rolling up. You lose if the price remains the same or decreases or appreciates only minimally. I view these situations as insurance or protection of my initial profit. In other words, the ETF can drop in value to the strike and I will still have maximum 1-month profit. Let’s look at the current option chain to analyze:
TLT currently trades @ $91.62
You sold the August $91 call
B-T-C the $91 call @ $1.60
S-T-O the $92 call @ $1.00
2 trading commissions @ $20
Total loss is $80 (160 + 20 – 100)
Stock now is worth $62 more per contract (91.62 – 91) as you are “buying up” share value.
Loss is $.18 per share or $18 per contract (80 – 62)
You win if the ETF appreciates by more than .18
You lose if the ETF declines in value, stays the same or increases by less than .18.
If your original calculations were correct and the security closes below the original $91 strike, then you will have lost $80 per contract.
If you have confidence in your system, you will not roll up early in the contract cycle. If you don’t, then you may want to re-evaluate the basis for your strike selection. You can always buy back the option on or near expiration Friday and roll out or roll and up at that time. You will be paying predominantly for enhanced share value and almost nothing for time value.
Alan
Just a quick note here to tell you that I think writing covered calls is one of the best things I ever started to do. I always new what it was but never took the plunge because I thought it was too boring and not enough ‘action’. I was thinking that making one or two trades a month left very little room to make and kind of money. Dude, I was sooo wrong. I started writing CC’s about 14 months ago and here I am with about a 480% return on my account. Yes, four-hundred and eighty percent. Now, I did have one stock that became a takeover target from another company that caused the stock to move about 4:1 in value with the options I sold and was pretty much locked there and I exited before the calls epired. That was a very nice trade but even without that move my account would still be up a very respectable 150% in the same time periiod, but I’ll take the 480%. Thanks for all the info you have here. Now the questions:
1) When your analysis is over and you are ready to put on your next CC trade, do you enter the CC position at the same time or do you enter the stock trade maybe on a limit order during the next few days for a better fill while expecting the options to gain in value ‘knowing’ that the stock will rise along with the option premium? I’m just thinking in terms of if the stock gets called away you will have more of a %ROI with the entry on the lower stock price. Or, do you just simply enter the CC position all at once since it’s the option premium that we are really targeting?
2)Let’s say your in a position and the maximum gain is about $1200 for the CC trade if the stock gets called away at the time the options expire. Now let’s say that the stock has a nice move upward and the current position is worth about $1200 and there are still 2 or 3 weeks to go until the options expire. I’ve had this happen a few times before and I’m in a move right now where the current value of the trade is almost the same as my max profit for the CC write. Would you close out the CC position now because the current gain is about the same as it would be if the stock was called away from you at expiration or would you let the stock continue to rise with the option value not moving as fast because of time decay? In other words, if you have a larger gain or the same gain now versus waiting for the options to expire, with the possibility of the stock coming back down, would you exit the position before the options expire to lock in that profit now?
Thanks again for the work here,
Chris
Chris,
Congratulations on your impressive success.
1- I purchase my stock and sell the option simultaneously. At that point in time, I have determined that I like the equity and the calculations are favorable. The deal is there and I take it. If I buy the stock and wait, it could go up and I win or it could go down and I lose. I take the deal and then look to properly manage my positions via exit strategies.
2- The maximum profit (excluding early contract exit strategies) is the option premium + share appreciation to the strike if an O-T-M strike was sold. If the stock has gone up in price, to unwind the position, we will buy back the option, most likely at a loss. Since the premium we pay to unwind our position includes time value, we will NOT maximize our potential monthly profit. I do look to unwind my position if the stock is heading south and I want to avoid major losses but not in the scenario you are referencing.
Alan
Alan,
Since the August options will expire next Friday should I look at the September options if I wanted to sell a covered call now?
Thank you.
Amy
Amy,
With a solid watchlist, you may find that there are stocks that will still generate excellent returns even in 8 days.
For example, FUQI, one of the top performers on the IBD 100, is currently trading @ $27.45 (at the time of my response). If we sell the August $25 call, the calculations would be as follows:
S-T-O $25 call @ $3.10
ROO= 310 – 245/2500 = 2.6%
Downside Protection = 245/2745 = 8.9%
This means that we are guaranteed a 2.6%, 8-day return as long as our shares do not depreciate in value by more than 8.9%.
A good deal? You decide.
Alan
CTSH and PWRD:
These are two of the stocks on my watchlist that had particularly impressive ERs, both in terms of earnings and revenues. Both are also flirting with new 52-week highs.
Check to see if they belong on your watchlist.
Alan
Hi Alan:
Thanks for answering my previous questions.
If I may, …….. Why is it that there are often trades that fall outside of the bid/ask spread. How do market-makers profit from them ?
Barry,
The bid-ask spread of option quotes is in a constant state of flux just as is the price of a stock. When you see the “last” price of an option fall outside the current bid-ask spread, it is a product of the fact that the spread has moved from a previous position.
We, as retail investors, sell at the bid (the lower) and buy at the ask (the higher). The difference represents the profit for the market makers. As you can see, we are buying high and selling low. That is another reason I like cc writing. We are generating an immediate profit and then managing our positions through exit strategies. We also have more cash to re-invest, thereby compounding our money in minutes!.
Alan
Hi Alan,
Another warning about Earnings Reports. Somehow I got the date wrong for NTES and bought it a few weeks ago. The ER came out yesterday and it’s down 10% today. Lucky for me it had a run up prior to the drop and I also got a good price for the option. So I’m at break even and I’ll be double checking my ER dates going forward.
Dave
Here are 2 free sites to double check ERs:
http://moneycentral.msn.com/investor/market/earncalendar/
http://www.earningswhispers.com/
Keep up the good work.
Alan
Hi Alan: Love the books. I have put together my first watch list and paper trades (I am using a virtual trading account on the CBOE website, the only one I was able to find that doesn’t require a funded account to use). Very exciting, but I do have just a couple of questions about the construction of the watch list and order entry.
I understand that in order for a stock to be included on the watch list that it must have strong fundamentals as determined by the IBD100/Investors.com SmartSelect Ratings Checklist and the StockScouter rating. My question has to do with the technical analysis. Does the stock have to have positive signals from ALL the TA tools before it makes the list? My interpretation seems to indicate that the upward direction of the 20-day EMA, and having the price bars above the 20-day EMA, qualifies a stock for inclusion on the watch list, and that the other indicators (MACD, Stochastics, Volume) are used for confirming buy/sell signals. Do I have that right?
Also, do you ever use a debit limit order when entering trades? I have found this order useful because I sometimes have troble getting to my computer during the day. I can place the order before the market opens, and not only do I get to buy the stock and sell the call simultaneously, it also allows me to play the bid/ask spead at the same time. Any thoughts on this?
Thanks for your time.
Best regards,
Tedd
Tedd,
I’m glad that my books have turned you on to this type of investing. I congratulate you on taking this initial time to paper trade.
You absolutely have it right on technical analysis. My preference is to add stocks to my watchlist that are uptrending. As they say on Wall Street: The trend is your friend. If one of these equities should enter a period of consolidation (move sideways), they are not necessarily bumped from the list or even my portfolio. I use the confirming indicators to further enhance my stock selection decisions and for buy/sell and strike selection determinations. They also play a major role in exit strategy executions.
As far as placing a net debit order pre-market, this would be a good solution since you can’t get to the computer during the day. Many investors prefer this over “legging in” if their online discount brokers permits. You may want to set the net debit .05 higher (pay a drop more) to enhance your chance of execution. Further discussion of this topic may be an idea for a future journal article.
Keep up the good work.
Alan
Hi Allen,
I’m new and I may have something out of order. It wouldn’t be the first time as I found your Exit Strategy book first which led me to your Cashing in on CC book. By the way, I’ve read several other CC books and yours is by far the best organized and explained.
I paper traded for 3 months and did very well following your books to the letter. But continuing to tippy-toe into this, I decided to use some QQQQ’s I already own.
I did STO AUG 38 call @ 1.19 last month (average sell around 7/22).
I’m embarrassed to admit my basis in QQQQ is north of $50 and maybe that’s the problem. As Friday expiration draws near, the exit strategy is looking cloudy to me:
1. Assignment.
2. Rolling out looks meager but okay.
3. Rolling out and up looks like a loss.
I’m expecting QQQQ to continue up. If I roll out this month and the calcs continue to be similar next month, could this be a spiraling hole of devalued premium by the time share prices reach my basis?
Should I have bought new QQQQ shares simultaneously with the STO AUG 38 for my education?
Maybe assignment is the way to go as I would keep all the premiums less commissions. There could be some price volatility in after hours trading while I wait to buy them back.
Any words-of-wisdom for a neophyte?
Jim
Jim,
First let me thank you for your generous remarks and welcome you to the world of Blue
Collar Investing.
Some points to consider:
1- Owning the Qs north of $50 makes you part of a very large group of investors. You’re not alone!
2- When you sell a call, you are agreeing to sell the security at that price and that becomes your cost basis, not your original purchase price. At that point in time your shares are worth $38 (unless below the strike at that time) and you’re deciding what to do with that cash.
3- It’s a little early to execute an expiration Friday exit strategy but if we did with the current numbers, here is what you would be considering:
4- You can roll out:
B-T-C @ $$1.89
S-T-O @ $2.29
ROO= 40/3800 = 1.1%, 1-month return
Downside Protection = 163/3800 = 4.3%
5- You can roll out and up to the September $39
B-T-C @ $1.89
S-T-O @ $1.58
Now this appears to be a loss of .31 but it’s not because we are also “buying up” the value of our security from $38 to $39, for a +1.00. Therefore….
ROO = 1.00 – .31 /3800 = 1.8%
Upside potential = 37/3800 = 1%, for a possible 2.8%, 1-month return.
6- I’ll leave it to you to calculate other strikes or you can use the ESOC (What Now tab). The math can be a little tricky and that’s why I created the ESOC, excel calculator.
Alan