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 entry was posted on Friday, March 23rd, 2007 at 12:07 pm and is filed under Covered Calls, Trading Tips. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.