Regarding the writing of dips (pullbacks) in a stock, here’s a great question from a CallWriter member that will make a helpful post, along with my response. The member asks, “I’ve made two trades already - one good and one not so good, but I think I’ve learned something I want to confirm. Both stocks exhibited uptrends and in my haste to get into the trade, I traded before the stock retraced to the 50 day MA. Both retraced, so now I’m wondering: is it better to wait and confirm strength of the uptrend as it bumps off the 50MA before making the trade?”

When a stock is uptrending you cannot know for sure when it will pull back. You can see points at which it likely will pull back to the 50-day moving average, assuming the advance/pullback waves come at the most likely points. Of course, they don’t always come precisely where we predict! Better yet is to buy and write the stock at a point where it has pulled back to the 50-MA support level, which is known as writing a dip (pullback). This technique allows an OTM write with a solid expectation of getting called out after the stock advances again after testing the 50-MA. Even if not called out at the OTM strike, the stock should be up after the MA test and you can rewrite it. You’re making a lovely return either way.

Alternatively, buy the stock on the dip but wait to write the call until the stock has advanced a couple of bucks, which brings in substantially more premium – this is the “legging in” technique.

Suppose a stock is moving up, hits 31.25, then pulls back to the 50-MA at 28.50. By buying the stock on the dip you can either write the 30 Call with a good expectation of being assigned for a nice return, or wait until the stock moves back up to, or past, the $30 range to write the 35 Call, which brings in a fatter premium than writing the 35C when the stock is at support.

Obviously, it makes sense to wait until there is confirmation that the test of the 50-MA is successful before buying the stock. This depends on your comfort level with doing technical analysis and your confidence in the stock’s trend.

But - suppose you wrote the uptrend already and now find the stock pulling back to the 50-MA. No problem! Buy back the short calls if doing so would yield a meaningful credit, then write another call once the stock has tested support at the 50-MA and moved back up. In other words, trade the calls in this situation. Stocks that move around present opportunities to trade the calls.

If you sold a call for $1.25, the stock pulls back to support and you can repurchase the calls for $0.60, you are picking up a $0.65 profit. Then when the stock moves back up you can resell the calls.

Remember that trend lines can act as support as well, and the best setup for this trading is where the trend line is the same as the 50-MA.

This post originally discussed a variant of a covered call strategy to be taught at my March 10/11 seminar, which has come and gone, so I have updated it to deal with emails received. Comments generated were eliminated since they are not applicable to the revised post.

This strategy involves writing a covered call and adding a protective put (known as a “married put” when the put is part of the trade at entry). The put can be NTM or ITM and will typically have an expiration several months out, perhaps the nearest LEAPS put. The concept is to write calls against the stock with the long put backstopping the trade. The downside risk in the trade is the amount the trade’s net debit exceeds the put strike.

Suppose we buy NSM today (April 5 as I revise this post) at $24.64, write the May 25 Call for 0.90 and buy the JAN-08 25 Put for $3.10; our downside risk is $1.84 (26.84 net trade debit - 25.00 strike) - or 6.8%. The simplest approach is to keep writing NSM until called. And if called, buy it again and keep writing. This is of course an oversimplification, since we can trade the calls, trade the stock, etc. Once we pull in an additional 1.84 in credits from trading or option writing, the trade begins to make money. Any transaction that would yield a profit or gain in a covered call trade adds to the stream of credits generated, and any transactional loss adds a debit.

The protective put construction eliminates risk once enough premium or trading gains are brought in to recoup the put premium. In the foregoing example, there is no downside risk (other than generating trading losses) unless you wind up buying NSM at some point above the 25.00 Put strike - which might leave an exposure gap above the put strike.

The ITM put, a little different animal, eliminates downside risk once enough premium or trading gains are brought in to pay the time value in the put - of which there ideally will be very little. If the stock falls, keep writing it, or buying it again and rewriting it. The goal ultimately is to sell the stock by exercising the long put, which recoups the put cost.

The risk in the ITM put construction, interestingly, is that the stock moves up too much. Assume in the NSM example that we bought the JAN-08 30 Put instead of the 25P for 5.90 and NSM gapped to $35 and stayed there, or kept moving up. We would be called out at the 25 Call strike, and the ITM put that cost 5.90 would be seriously OTM, with a greatly reduced value - probably a 1.00 or less. We might eventually trade our way out of the situation, but this would not be a fun position in which to be.

At the appropriate time, either exercise the put to sell the stock or sell the put itself, depending on where the greatest advantage lies. Obviously, the trader can do a lot to engineer strikes to achieve more or less return, with corresponding risk levels, in any put-protected covered call write.

The new “portfolio margin” rules discussed in other posts will really power this strategy to the moon. On April 2nd the new rules came into effect, which base available margin on the portfolio’s risk. It will be possible to run a covered call trade with protective put, putting up only about 5% of the trade cost. The long-term married NTM put eliminates all but a small portion of the risk and will be ideal for using portfolio margin. The ITM put still will pose a risk as noted above that is substantially higher.

Please don’t get misled into running a trade with inappropriate risk levels using too much PM margin simply because you can. Inexperienced traders focus on how much they can make; experienced traders on how much they can lose.

Before everyone takes me to task on the “nearly riskless” language, I understand that there is no truly riskless trade. Shareholders can be wiped out in a bankruptcy reorganization, for example. I have seen traders turn a problematic but salvageable trade into a disaster by poor trading, and have done that myself. Any put-protected covered call strategy relies for ultimate profitability on generating a stream of credits from option writes or trading gains (or both) that exceed the total debits. Trading losses generated while in the trade will either eat up some of the return or result in a loss. And these trades are not “riskless” to the downside until the cost of the put has been recouped.

I will be writing more on the subject from time to time. You might be interested to know that we have been playing with this strategy for a while now (I had always pooh-poohed it as like watching paint dry) and are working on new lists both for current-month collar trades and covered calls with long-term protected puts. We are experimenting to see what parameters yield the most useful trades. These trades are becoming of greater interest because of my belief that a new bear market could be in the offing. Stay tuned.

I understand that puts have been around for a long time, since about 1977. Buying long-term protective puts, both for covered calls and long stock, has been around about as long. This strategy is nothing new and I certainly can make no claim to having invented it (no one could honestly claim that), although my approach - especially to trade selection and execution - is not the same as anyone else’s.

I have bought long-term puts quite a few times to protect covered calls and have bought long-term calls and written current-month calls against them. I have been burned buying long-term ITM puts after a covered call position fell and I averaged down, because the stock came right back.

Every strategy works if done right. Protective puts are just another tool (whose cost must be recouped), and they are by no means required in order to write covered calls with consistent profitability. But if you like the idea of using protective puts as essentially a stop loss technique - where you know the maximum possible loss going in - some variant of this strategy might just be for you.

After a 416-pt. selloff on Tuesday, the Dow Jones Industrial Averages ($INDU) sold off this morning down to 12,059, then ralled on good news from the manufacturing front to close at 12,234, down about 34 points. I’m encouraged by the market’s ability to recover this afternoon. But… tomorrow is Friday, and a lot of traders will want to be flat going into the weekend, which could provoke a selloff, in which case we could see a good morning tomorrow then a bad afternoon as traders get flat.

I always stress to covered call writers to look at the weekly chart as well as the daily. The following weekly chart for the INDU illustrates why. Note how, despite the stellar gains since June 2006, volume has been declining since April.

Also note the MACD - the fast and slow lines have been essentially flat since late October and the MACD histogram has been declining since August. Thus despite the DOW’s impressive runup since July, we are seeing some bearish divergences.

Notice how the 50-day MA is still a long way away - about at the 11,715 level, which is very close to the 11,730 50% Fibonacci level discussed in my Black Tuesday post. This suggests to me that the DOW is looking for the 50-day average.

The whole question is whether the worst is over or, as I suspect, we’re not through with the correction. The bigger question is why the selloff in the Shanghai market caused a selloff worldwide; this doesn’t exactly scream bull market to me. It could be that the bull market still has legs and this week’s action is just a needed corrective. It’s too early to tell, but I think the correction is not over and the market will find a Fibonacci level. In fact, we have almost hit the 12,000 (38%) level already, so I would think the 50% level is a more likely target. (I don’t know if a major bear market is beginning, and neither does anyone else.)

For longs and covered call writers, keep a close eye on the market and your stocks. If further weakness is demonstrated, consider buying protective puts, closing the positions or rolling the calls down and out (using multiple rolls, if necessary).

Some people are buying OTM puts for April or May on the logic that they protect against a serious market slide and, if the market recovers without much more hiccupping, the puts will still have enough time value in a couple of weeks to not produce a loss on selling the put. (This is why March puts make less sense - time decay will really kill you between now and March expiration if there is no further market decline.)

Protect Yourself:
In a sense, this correction comes at an opportune time. If you are truly concerned about handling this correction, you should be at my Orlando, Florida Prosperity Powerhouse Covered Call Seminar being held on March 10th and 11th - next weekend! We will be talking about how to react to this and other situations when good trades go bad. Truly, you don’t want to miss it. Details here…

There are two seats left, and they will be gone soon. Call us at 352-377-3500 if you have any questions. There may not be another opportunity this year to get this seminar. If you are concerned about this week’s market action - you need this seminar.

Now, a final thought about puts: the beauty of long puts is that, on a stock decline, you can always decide to keep a stock you think will recover and take profits by selling the puts.

Yesterday’s WSJ featured an interesting article by James B. Stewart (p. D3) on a technique for portfolio writing. The author writes covered calls at pre-selected Nasdaq composite index (COMPX) levels. When the index hits 2,515, Stewart sells call options on the shares in his portfolio to bring in extra income, rather than taking profits by selling the shares themselves.

Stewart explains, “By selling calls when the Nasdaq hits my selling target I have never had to deliver a share. [emphasis JDB’s] I have kept the cash I gained from selling the calls and [also kept] the shares when those options themselves expired worthless.” He goes on to say that, “This past year my covered-call options strategy has been working well, even as the market has continued to climb.”

Stewart sold long-term, out-of-the-money (OTM) calls last year. For example, in SEP 2006 he wrote $75 APR Calls on Devon Energy, which look set to expire worthless. He now thinks the better practice is to wait and sell calls at a market peak rather than writing deeply OTM calls. Though he did not enunciate it this way, by selling calls at a market peak (or strong resistance level), one does not need to sell calls quite so far OTM. In fact, if you were confident of a pullback, you could write ATM calls, or even ITM calls, relying on a pullback to make the ITM calls expire worthless. The further out in time, the larger the premium will be. Give the stock enough time to pullback, though, especially if the write is ITM.

Writing calls on portfolio stocks at market peaks or strong resistance levels is just one more of the seemingly endless ways traditional stock investors use call options to produce an income from a portfolio - just like fund managers do - but by no means the only technique.

Stewart noted in conclusion that, “Indeed, with a few of these [covered call] positions incorporated into your portfolio you’ve got your own hedge fund - without any of the exorbitant fees most hedge-fund managers charge.” I couldn’t have said it better.

If you own stocks, make them pay some rent! Thanks to my buddy and trader extraordinaire, David Skidmore, for a heads-up on this WSJ article.