Market Sell-Off = Opportunity
October 19th, 2007 by John BrasherThe market is selling off today, the DOW down 328 points and change as I write this, with the Nasdaq Composite and the S&P 500 down an equivalent amount. It’s the 20-year anniversary of Black Friday, which means nothing except in the human psyche. As I wrote days ago, there still is a lot of volatility in this market. I doubt if the bear market is here, but if the market keeps tanking, I may have to adjust my thinking.
Someone once asked legendary economist John Maynard Keynes whether a position he espoused wasn’t contrary to an opinion expressed at an earlier time. Keynes responded, “When the facts change, sir, I change my opinion. What do you do?” Since I don’t see any reason for glumness, I doubt that a bear market has begun, though when earnings are clearly deteriorating across the board, I may change my mind.
Those who were alert this morning to weakness in the market bought huge amounts of index puts and have been well rewarded for their perspicacity. But how now for covered call writers?
CLOSE THE SHORT CALLS
First of all, you should be closing any short calls if the stock is down with the market pull back, which most are today. Remember that you rack up a nice little credit when buying back the short calls for a price lower than you received upon writing them.
MORE PRICE SLIDE
If you are concerned about a continuing market slide, you could roll the calls down to a lower strike, and then close those also if the stock continues to fall. Be careful about this, however, since if the market and the stock rebounds, you can be trapped in the new, lower-strike calls and be put in the position of having to either close them as the stock advances again (paying more for them than you received) or be called out at a loss. Writing calls at a lower strike when the stock has temporarily taken a dip is a good way to put yourself in the assignment trap.
If concerned about a further slide, consider instead buying a protective put that is two or three months out. It will gain value impressively as the market falls, if it falls. Yet if the market appears to be bouncing back next week, you can close the puts with only a small debit. They put you in the driver’s seat. TIP: After the open next Monday, give the market a half-hour before doing anything; get a feel for direction. if futures are sharply down Monday before the open, get ready for another sell-off day. If futures are up, it could augur a recovery day.
WRITING NEW CALLS AS STOCK RECOVERS
As the market and your stock snap back from this sell-off, don’t write any calls with a strike below your cost basis. Let the stock regain some value, since you don’t want to write calls that you will be forced to buy back.
An alternative technique that can work well when the stock is snapping back from a sell-off is to buy calls ATM or slightly OTM and write higher-strike calls against them. This creates a bull call spread, in which the potential profit is the total spread less the cost of putting the spread on. Or if quite bullish, simply buy some calls. This is a much better technique than writing calls when the stock is down, in expectation of the snap-back.
It is not a cause of major concern when the stock is down with a market pullback. The real concern is when the stock is down on its own. When the market pulls back like this, look for ways to profit from it: “How do I make a buck off this?” is the question to ask.
October 27th, 2007 at 8:41 pm
John:
What do you think about selling deep in the money calls with the market possibly cracking at this Dow 14k level? I’m trying to rack up 2-3% safely with deep near month in the money calls. I’m selling cov calls on 130k and I hate to take a hit in valuation but would like to get some decent cash inflow. I know you probably dont want to hear this but Im following the technique of Hooper and Zalewski who have techniques to earn income on a downtrending market as well as an uptrending one. I just like to be in the uptrend and get called out each month.
Ken
October 27th, 2007 at 10:24 pm
Hi Ken, although no one offers anything like my SuperPut lists, the truth is that no one has a lock on covered call wisdom; the “secrets” are all out there. Their technique is no different essentially than anyone else’s, because we are all playing with the same Tinkertoys. Forget about rules for a moment: the only rule that makes sense is to look at what the stock is doing and ask yourself how to make a buck off it. The best return, uncalled, always is the current-month ATM call. To write anything else, you should have an articulable reason.
DITM calls are used on downtrending stocks, stocks at major resistance or other obvious failure points, and on stocks that trade in a wide true range (written at range tops). Selling DITM calls makes no sense unless the stock is falling or you think it about to fall and you want 1) more downside protection and 2) the ability to buy back the calls for a profit if the stock falls. As the stock falls, the DITM calls should be rolled down as opportunity permits or necessity dictates. Similarly, be very cautious about rolling too far. Writing at or below major support usually is a mistake, because a snapback in the stock traps you in the deep call and having to buy it back. Let the STOCK tell you what trades to put on.
On the other hand, if the stock is moving up strongly, does it make more sense to write a call than hold the stock? Not usually. A CW member wrote recently about RIMM, which he bought at $38, now $125. He keeps having to buy back his short calls (incurring trade debits and increasing his cost basis) to roll them up, giving away much of the stock’s rise. I suggested he get out of the stock’s way and let it rise; perhaps BUY some calls and hold them for extra pop, or write higher-strike calls against them to create bull call spreads. You can’t argue with the chart. RIMM is no doubt overvalued, but it’s a rising star and not very appropriate for covered calls, unless you are content to write it and be called out for a profit; buying it again and writing it. But to hold it long term and keep rolling calls as it rises is just arguing with the chart. See the difference?
If a stock has fallen to major support and is recovering, then you have the RIMM situation, don’t you? Though I love covered calls, they are not always the only solution, nor even the best solution.
Regarding your market question, we just had a correction of over 1,500 points. I don’t think another major one is in order, although with this volatility and lack of conviction in the equities market anything can happen. Another major correction probably will be a double top and the effective end of the bull market -everybody is seeing the same chart as you. Playing the volatility is the right thing. Sell calls at the high, roll them down; wait a while to write calls as the stock recovers so as not to be trapped in a lower strike call.
While we’re at it, why not buy a multi-month protective put on the falling stock? If the stock finds support and seems to want to recover, sell the put; otherwise exercise it once you’re tired of pulling premium out of it and profits from the rolls down. Remember, you can always sell the put.
Are you closing the calls advantageously as the stock trades in its natural weekly or monthly range?