From the stocks offering the best call premium, covered call writers select trades (I hope) by choosing the best companies in the best industries in the best sectors. This is the holy grail, even if many of our trades necessarily fall short.

Ah, but where to find good industry info? No one puts it together in any kind of ideal form for covered writers, but there are a lot of good free resources out there. Here are links to the best and most usable web sites:

Yahoo Industry Browser

Yahoo provides almost exclusively fundamental information, but very detailed. Makes you wonder why they stopped there, when there is so much more valuable industry information that traders and investors could use…

Barchart.com Industry Groups

Barchart.com Performance and Fundamental Views

Barchart.com Sector Changes – Ranked by Three Months

The Barchart.com pages are very powerful and offer both fundamental information (and rankings) as well market performance. The Industry Groups page has a chart associated with each industry, which is handy. Some customization is built in; for example, clicking the Sector Name column heading will show industries alphabetically, or you can arrange them by performance over 1, 3, 6 or 9 months, etc. You can also switch between fundamental and market performance views, which is helpful.

Prophet.net Industry Performance

The Prophet.net page’s default setting arranges the industries by stock market performance, with the best-performing industries in green at the top shading to worst-performing (red) at bottom. Click on the industry number code and you get a detailed quote, plus a chart for the industry itself. Prophet.net uses the same Sector/Industry groupings as Yahoo (and CallWriter), which is handy. Click on the industry name and you get a page with charts for all the stocks in the industry. You can arrange the industries by alphabetical or reverse alphabetical order, or by performance. Clicking the “See Current Performance” link on the page gives the same industry performance rank but presents the information from a different perspective. Very cool, and very close to how I would design an industry page.

Morningstar Industry and Sector Performance

Shows both sector and industry information by market performance. Also has performance by company size (Stock Style). Not my favorite, since the same general information is available in more usable form from either Prophet.net or Barchart.com, both of which sites are far more customizable and useful.

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There is some great data at these sites. If you’re wondering why we don’t integrate some of this data into the CallWriter Research page, just stay tuned. Try them out and see what works for you, because nothing else matters. Enjoy.

In the April 17th issued of my Money Newsletter (”When a Stock Pulls Back“), I discussed Network Appliance (NTAP) and Allegheny Technologies (ATI), both of which appear to be pulling back to a moving average or trendline. If you have not subscribed to the newsletter, you can still get that issue if you subscribe this week.

NTAP is $37.18 as I write and since December has moved around quite a bit, from the December high of $41.56 to the recent $34.69 low. This is quite a bit of difference over relatively short time frames, about 20%. Wide-ranging days happen but are not frequent, but wide-ranging weeks are not at all uncommon. This movement makes it possible to write ITM calls and buy them back more cheaply for a profit.

Covered call returns will be low when implied volatility is low, thus many would question the point in writing calls on a stock like NTAP if volatility is low. True, low IV means that a buy-write (to buy stock for the purpose of writing calls) is a poor choice for NTAP. But for those already long NTAP, writing ITM calls at a high point in a stock’s range of daily movement - and even better, weekly movement - creates a profitable call trade when the stock pulls back.

ATI is $114.94 as I write this. It can oscillate about quite a bit, also. Just today the low and high prices are $111.45 and $115.05, a $4.50 difference so far (yesterday even larger). It can easily move over 4% in a day, much more in a week. Days with $2.00 of movement in a trading day are not at all uncommon. I stated in an earlier post that ATI would in the near future pull back to the 50-MA, which currently is about $107.20, and then resume its uptrend. It keeps nosing closer and no doubt is heading there. But - you don’t have to wait for a pullback to the trend with cymbals crashing; you can make money on it all the time.

Unlike NTAP, ATI offers good premium. ATI in fact perennially occupies a top spot on our S&P100 list and normally offers good covered call returns every month. IV is high compared to historical volatility, and time value is excellent.

Thus ATI is a good covered call candidate, and savvy call writers are milking it like a cow. If putting that trade on now, I would probably write a May or June ITM 110 call in the expectation that it will pull back to the 50-MA, giving me a chance to close the short calls with a fine profit - maybe even close it earlier on another day like today. If you are short the 110 already, I hope you closed that call today and are writing it again!

In the last month alone, ATI offered numerous chances to write calls and buy them back at a profit. Think of this combination of fat time value and price movement as a gift from Wall Street. Traders all over are scalping these moves, and we should be, too.

When ATI resumes its uptrend, I would write it OTM a couple of months - heck, the JUL 120 is bid at $6.10. Or wait for a new price advance off of support and continue the tactic of writing ITM and closing the call on pullbacks. Take advantage of stock price movement when you like and trust the stock, meaning the company is solid. When the stock moves around and there is fat time value, too (ATI), you’ve got a heavenly combination.

How often should you scalp a stock? If it is possible to do once or twice a week, why not?

On April 23rd, I wrote a blog post on Alcoa (AA) which pointed out the different readings from the daily (showed an uptrend that may have topped out) and weekly (showed stock possible failing at the range top of a long-term channel) charts. I pointed out that the key was for Alcoa to find support at the 50-MA on the daily chart, which it may have done, and break the range top. Note the following daily chart:

(Click on chart to enlarge it)

The stock held the 50-MA and today spiked up on news that Alcoa is looking to sell lackluster units. Alcoa opened on a nice gap up today above the 50-MA and then traded down to fill the gap and back up, piercing the upper Bollinger Band on news. Note that whenever Alcoa broke above the upper band briefly, a pullback occurred soon after, except for the break in mid-January, which was a very slight rupture almost too small to be called a break. It is of course too early to tell if today’s break above the upper band signals another pullback or a new surge in the stock.

Certainly, the metals industry is quite strong, and should not be lightly bet against. Yet for Alcoa’s 2007 uptrend to be considered still in place, we need to see some closes above the $36 level to break the long-term range top and then continued movement upward. It could well pull back from this spike - too early to tell.

Interestingly, implied volatility (IV) and therefore premium has not spiked along with the stock price, because speculators are not jumping on Alcoa. Thus to write the MAY 35 (1.40) or 37.50 ((0.35) Calls would bring in depressingly little time value premium - and June is not much better. The punk amount of time value available, which indicates low IV, indicates that long calls on Alcoa may be a better deal than writing calls. The low IV makes AA a poor buy-write candidate, though even if long the stock those call premiums aren’t much more enticing.

What about those of you already long AA who expect it to pull back again? Writing a price spike like this on a great company that you enjoy owning can be rewarding, because the short calls can be repurchased at a profit if the stock pulls back. But the lack of time value in the Alcoa calls means that all of the profit on a pullback would have to come from the pullback itself, since there is no IV to collapse.

However, only an ITM call will pull back with the stock at anything close to a dollar-for-dollar delta, and the amount of time value in the ITM premiums is so low that you’d better be right about a pullback coming.

Alcoa Inc. (AA) illustrates the importance of looking at weekly as well as daily charts. On a daily chart, it was in a reasonably strong uptrend through early April, when it quit making higher highs and lows and appears to have gone into a range. AA is pulling back to the 50-MA, which tends to act as support at the trendline, suggesting a possible resumption of the earlier move up if it bounces off that support level.

Now let’s look at a weekly chart for AA, and we see in a very different light the uptrend that began in October:

(click on charts to enlarge image)

Note that what looks like an uptrend on the daily chart appears on a weekly chart to be merely an up-leg in a long-term trading range, with the stock now pulling back from resistance at the $36 range top. We would normally expect Alcoa to continue downward to the main or even extended range bottom. But - stocks don’t range forever; every range ends sooner or later. Note that the 50-MA is not very useful on the weekly chart, though it rules on the daily.

The careful observer will note that AA might be forming an ascending triangle, often a bullish sign, since conventional wisdom suggests any trend in place will continue as the triangle resolves at the tip. Yet triangle is as triangle does. If Alcoa finds support again at the 50-MA/trendline and makes another run at resistance, the case for an ascending triangle will be strengthened, and a couple more runs at the range top would forecast even more strength, but it is too early to tell. A bounce off support would be somewhat bullish but far from conclusive, given the strength and depth of the long-term range.

This is not an in-depth article about how to trade or time Alcoa, of course. I’m just making the point that it’s very common for daily and weekly charts to show different things; sometimes radically different things. The point is to check both charts and make sure of what you’re dealing with.

The metals industry is strong, and an announcement confirming takeover rumors about Alcoa would move the stock up, thus bears should proceed with caution.

It is too early to buy puts or take other bearish action (bear call spread, naked call, etc.); we need to see a convincing breakdown below the 50-MA and trendline on the daily chart. If it convincingly breaks that support level, though, it is bear food.

Covered Calls:
Covered call returns on AA are poor at this time, so it is not a good buy-write candidate. If you already own it, consider waiting to see if it holds support before writing it again. If it bounces off the 50-MA, write it higher and perhaps further out for larger premium. But if it breaks support as discussed above, writing deeply ITM calls on portfolio shares might be in order to pocket as much as possible of the pullback. Or in the event of a breakdown below support, consider buying a long-term put, which would free you to write calls and pull in premium income, leaving you eventually with the choice of exercising the long put or flipping it and keeping the stock.

This is a follow-up to my April 9th post about Dendreon (DNDN), a pharmaceutical maker, or rather would-be maker, in which I noted an extreme price spike in the stock due to possibly favorable news on its Provenge drug in development. I speculated that the stock would not hold price and pointed DNDN out as a bad covered call play, but a good short, puts being too expensive. DNDN had spiked to $21.78 at the time of my post and later reached a high slightly over $25.

Of course, a bear call spread was a potential trade, too, or a naked call. See how one trader actually handled DNDN.

A CallWriter member tried to short the stock but found none available to borrow from two different brokers. He also found, as I suggested, that the puts were too pricey, but nonetheless bought the OTM May 17.50P and closed it for a .30 profit, not bad. When the market sees an aberrational spike like this, options get really expensive. They remain expensive as volatility continues, since people are willing to pay a big premium for options.

His big score, though, was writing the ITM May 20 Call for $8.20 when the stock was $24.35 (not too far off the stock’s high). He exited the call when it fell to $2.60, a pretty good score of $5.60 a share! Note that the call’s low has been $2.00 since the stock’s high, so he got most of the possible profit. Naked calls normally are written at an OTM strike, above a strong resistance level or at least above the stock’s apparent high-water mark, yet this trader sold a deeply ITM call with $3.75 of time value in the next expiration month. The trader’s real risk obviously was a continued move up in the stock. But the trader won if 1) implied volatility collapsed, even if the stock remained at that price level or pulled back only slightly, 2) the stock price collapsed (as it did) or 3) when time value eventually evaporated close to expiration (which certainly would have happened as expiration approached and the ITM call’s price moved close to parity), in either of these events enabling him to close the short call at a profit. Significantly, he sold a May call, which gave him time and room to operate; June calls were not then available and the April call might not have allowed enough time for a pullback or change in volatility.

In other words, the high time value - which would have been poisonous for someone buying the calls - worked in favor of someone writing the calls. Remember, buy low volatility, sell high volatility, and this is an object lesson in how to do it.

Note that someone not approved to write naked calls could have done a very similar trade by also purchasing a higher-strike call, turning the naked call into a bear call spread. However, the high level of implied volatility would have made a bear call spread less profitable, due to the high cost of the long call, even at the 30 strike.

This ITM naked call was a smart, gutsy play - and the trading was pretty icy. Good work, Barry!

This is probably one of the top three or four questions I get: when can early exercise (exercise before expiration Friday) of call options be predicted to occur? Of course, only calls that are in the money (ITM) will be exercised early - meaning the stock price is higher than the calls’ strike price.

ITM calls are as a general rule are only exercised early when expiration draws close and they are trading at or below parity - “parity” means that an option is trading exactly at intrinsic value with no time value at all. This generally happens in the last week or possibly two weeks before expiration; usually in the last few days. When there is time value left in the calls, it is more profitable to flip the calls than to exercise them and sell the stock. When the call’s price is below parity, exercise can be expected, and the further below parity the more likely exercise becomes.

Thus I don’t worry about early exercise until an ITM call gets close to or at parity. Even when parity is reached, though, the covered call writer has the option to close the call or to roll out a month (or up and out) to get more premium or avoid losing the stock, if desired. Covered call writers have a lot of say in whether they are called out or not.

Still, early exercise of ITM calls is never assured even when calls are trading below parity. But if open interest in the calls is high (meaning a lot of professional traders) when this occurs, exercise is quite likely.

This week’s Money NewsLetter for covered call writers discussed how to handle a stock that is pulling back to a clear support level, either a trendline or 50-day moving average - and noted how covered writers are free to trade the calls as the stock price moves around. What many covered call writers don’t realize when getting into the game is that we are not limited to selling calls once only!

Many stocks will oscillate in price, and when they pull back we can buy back the calls for less then we sold them - which creates a profit. Then when the stock moves back up, sell the call again. This is known as trading the calls and you can do this over and over. Look at the effect on your account, assuming you bought a stock for $20, wrote the 20 Call for $1.25, bought it back and wrote it again:

This is a simple example, but closing the call out at a lower price and reselling it when the call premium fattened up again on the stock’s snapback increased the return from 1.25 to 1.75, a 40% increase in the return. On stocks that move around a lot (swings of 1.00 to a few dollars intra-day or intra-week), the calls can sometimes be traded several times before expiration.

The amount that the call premium moves in comparison to a price move in the underlying stock is known as the delta. ATM calls have a delta of about 0.50, while OTM calls have a delta more like 0.30 (call premium would fall 0.30 if the stock fell 1.00). But ITM calls can have a delta of 1.00 or close to it, meaning that the ITM call’s price can fall dollar-for-dollar with the stock, or very nearly.

The covered call writer’s goal is to cream a stock for income by writing call options against it. The beauty of it is that we can trade those calls. Those who knock covered writing assume that we write a call and forget about it, themselves forgetting that covered call returns can be bolstered considerably by a little judicious trading.

A member this morning pointed out a trade on our Pharmaceutical lists of the highest-returning covered call plays: Dendreon Corp. (DNDN), a biotechnology company. On this morning’s April expiration list DNDN was shown at $21.78 earlier and it was possible to write the APR 20 Call for 2.90 in premium (5.1% return) and the APR 22.50 Call for 1.80 (8.2% uncalled, 11.6% called). Nice returns with only 12 days left until April expiration on 4/21. [The stock has moved almost 2.00 in the time it took to write this post, so many of the numbers in this post may be really old.]

But not so fast, let’s take a closer look.

After being essentially flat for two years and seldom being above $5 in the last year, this stock went up in late March like a bottle rocket, leaving anything resembling support (including moving averages and trendlines) far behind. There was a huge gap from about $5 to $12, and the last couple of days’ upmove has occurred on decreasing volume (although if volume continues at this rate, it might make a liar out of me), as the chart below shows:

(Click on the above chart to enlarge it)

DNDN moved up on an FDA panel’s endorsement of Provenge, Dendreon’s prostate cancer drug, although some have questioned the propriety of an FDA approval. Given the uncertainty of better news on this stock (and even with better news, does it have much further to go?) and the fact that it has spiked so far above support, it is a dangerous covered call write. See my archived newsletter on writing price spikes for more thoughts in this vein.

It is a small pharmaceutical company that loses money undergoing extreme current volatility, which breaks just about every rule of conservative covered call writing. The cost of protective puts for a covered call position is quite high, and the spread on the puts is enormous - the MAY 22.5P was 5.60 x 6.10 as I write, a bid/ask spread of 0.50. The stock is moving fast enough that it is hard to get option quotes consonant with the same stock price!

The stock may well not be able to hold this price level without more good news, like moving toward closer to FDA approval, which is uncertain. It may even fall on further good news in view of all the speculators who have already bought the rumor. I see this stock as a short - a straight put buy isn’t indicated because they’re far too expensive. Even the OTM MAY 20P is going for 4.90. Sell high premium, buy low premium, remember?

Speculators are having a field day. Putting a covered write on this stock is a real gamble. It might work, but your fingers will be crossed (and your knuckles likely white) waiting for April expiration.

On April 2, 2007, the new Portfolio Margin rules came into effect, which are described at length in a recent CallWriter newsletter. The margin available under the PM rules is huge, as this CBOE margin comparison chart indicates.

Just take a look at that CBOE chart: the purchase of 10,000 shares of IBM at 97.73 would cost $977,300 with no margin. Under Reg-T margin rules, a covered call involving the sale of the IBM April 100 Call would require only $471,950 in cash, while the same covered call trade under the PM rules requires only about $130,000. But, adding a protective put would drop the cash requirement to run the trade to $37,538 under the PM rules - only 3.8% of the cost of the stock. (Don’t forget margin interest on the borrowed funds at over 8% p.a.)

As you know, Americans in general don’t save - our homes have for decades served as our piggy banks (spending derived from home equity loans largely fueled the US economic expansion of the past few years). But the astonishing amount of margin available under the PM rules represents a new source of liquidity for the trading public. Back in the great bubble market, it was not uncommon for traders to hock their homes to get money to trade.

Well, that won’t be necessary anymore for traders who qualify to use portfolio margin, because they will have fabulous liquidity without pulling equity out of their homes.

Use of such high margin will be very tempting and can allow the generation of returns heretofore available only to futures and forex traders. I would expect traders to be the primary users of portfolio margin, not investors.

As noted in an earlier post and as will be explored in future posts, I believe a recession or mini-recession is coming due to the cooling housing market and other factors. Since the stock market is one of the earliest leading indicators of the economy’s growth or recession, we can expect a bear market soon if the economy really is cooling off.

My first question is: if traders make heavy use of portfolio margin, to what extent will the additional liquidity created by trading on borrowed money artificially buoy the market? A major bear market, in which institutions and hedge funds are selling stock holdings and going to cash, will not be staved off by traders using any amount of margin. But how much difference will bullish use of the new margin make?

On the other hand, might traders using heavy portfolio margin for short selling (recall that PM was not available during the February 2007 market selloff) actually exacerbate the decline if a new bear market is initiated?

This is uncharted territory, so no one really knows. It will take a while for PM to become widely used, partly because many brokerages won’t be ready or will only gingerly put a toe in the water at first, but the trading sharpies will be the first on board with it, as always. It therefore may not be entrenched soon enough to make a difference in the near future. But the public tends to make use of new liquidity sources, and this is a big one.

Today, April 2, 2007, the new Portfolio Margin rules came into effect, which was the subject of a recent newsletter. The fixed Reg-T rules-based margin system in place for many years dictates that margin is utilized and calculated based upon each trade deployed and varying according to the trading strategy used. Under the Reg-T rules, the maximum amount of initial margin on a straight stock purchase is 50%.

The new portfolio margin requirements will be equal to the maximum potential loss on a portfolio based on an increase or decline of as much as 15% in the value of each investment held in the same account. Unlike the current Federal Reserve rules, the new rules will have the effect of aligning the amount of margin money required to be held in a customer’s account with the risk of the portfolio as a whole. The term “portfolio” in this context refers to securities in the same account; securities in one account will have no effect on margin in another.

I speculated in my newsletter article about what sort of suitability requirements brokers might apply for using Portfolio Margin. Under Chicago Board Options Exchange (CBOE) guidelines, expect your broker to require that there be a minimum of $100,000 in net liquidation value in your account in order to qualify for using Portfolio Margin. Interactive Brokers and OptionsXpress have both indicated to me that this will be a requirement. Other suitability requirements may be imposed as well.

So the new PM rules will not be for everyone. And for that matter, Portfolio Margin will not be automatically extended. All brokers will require an application to use it. Note that not all brokers will be able to roll PM margin out today, but Interactive and OX both should be deploying it already.

For covered call writes, epecially those involving a protective put, the margin available under the PM rules is huge. The CBOE has provided comparisons of the differences in available margin under the Reg-T and PM rules. If you’re interested and you qualify for it, check it out.