Quite a Wall Street day, the DOW down 362 points. Worse, it trended down all day and ended very close to the low, which does not augur well for tomorrow. I said on Tuesday of this week that the market might sell off without a 50-point cut in the FedFunds rate. I didn’t really expect a one-day sell-off of this size, but the point of the post on Tuesday was that the market is quite volatile, and ahead of a rate cut - you just never know. And truth be told, it might have sold off no matter what.

Interestingly, there are almost always stocks that are up on days like this. Microsoft was up today; not much, but up. Regarding my “Witch Hat” post from yesterday, I think MSFT is going to stick at the higher price level. If it didn’t come down today…

A lot of covered call writers like to write on these pullback down days, because you can get an artificial pop as the stock snaps back with the market. The key is that the stock is down with the market. If the stock is down on its own, or the stock (like MSFT) isn’t down with the market, then the rationale for a down-day write is not present.

This pop is quite real and we see it on larger time frames, as well. Look at just about any chart over AUG and SEPT this year. From the market bottom, stocks commonly rose with the market although volume didn’t increase for most stocks. That is, the stock pricess rose as volume fell, normally a bearish divergence. But when the market comes roaring back, divergences be damned - they just don’t mean much, because most stocks have then become lighter than air.

Which brings us back to down-day writing: when the market snaps back, good stocks will spring back with it. If you have been buying back short calls with the market’s fall, and you should be spanked if you haven’t, don’t rewrite the stocks just yet. Wait and write at a higher point. The down days are also a great point to get into a stock (some covered call gurus believe you should only write on down days), since you can either 1) write an OTM call and expect an easy assignment, or 2) leg in by purchasing the stock and writing calls at a higher stock price.

Now to the fun part: wait to buy the stock until you see the whites of the market’s eyes. Tomorrow could be another down day, so get a feel for market direction before doing anything, especially since the afternoons tend to be sell-off prone. And tomorrow being Friday, I don’t expect an up day, but it could happen. Better to wait for confirmation that the market volatility is occurring in a more heavenward direction - even this means not getting in at the “bottom.” (The bottom may be yet to come)

Did anyone buy protective puts on Wednesday? If so, I would like to hear from you - please post a comment with the gory details. The anti-gloating rule is suspended for you.

Ah, it’s Halloween, the time of year when the “Halloween Effect” - sometimes known as the Sell-in-May-and-Go-Away Effect - is about due to begin. Stocks very frequently begin rising on November 1st or thereabouts right through the end of April or sometime in May. It is a pretty consistent phenomenon, about which I’ve written before. Will we get the Halloween Effect this year? It would be nice if Messr. Bernanke and the rest of the FOMC committee would give us a 25-basis point rate cut today, which wouldn’t hurt the Halloween Effect one little bit. But like little kids waiting for Halloween to come, we have to wait and see.

Well, since it IS Halloween, let’s look at something really scary and dangerous. It’s real and it’s out there waiting for you. It doesn’t get little kids, though, gentle reader, it is looking for yoooouuuuu… the Witch Hat.

In years of writing covered calls and doing other types of trading, and years of seeing what CallWriter members have done, one thing sticks out: the Witch Hat. It is the sudden price spike that does not hold, but comes back down as fast as it went up, making a chart pattern that looks like a Witch Hat. It whipsaws unwary covered call writers (and other traders), spraying blood on the walls. OK, enough bloody metaphors, but the following chart provides a blood-chilling example:

Unsuspecting covered call writers sometimes see a violent up-move like this and rush to get in before it’s too late, perhaps buying the stock and writing calls to get in on the move, maybe rolling the short calls up if they’ve already written the stock. [Cue scary music] But only TOO LATE do they realize… the Witch Hat has gotten them. As the GM chart above indicates, bad things often happen to those who write price spikes, like the horror-movie teenagers who slip into the dark woods to neck… we already know what’s going to happen to them, don’t we?

I could show you other examples, but you get the “point.” Make the stock prove itself by holding the higher price; make sure it wants to live in the new trading range before getting in or rolling up. How much proof you want (how many closes at the new level) is up to you, but make sure you aren’t writing, or rolling up to, a Witch Hat. Keep your blood in your veins, where it belongs. (Whoops) They are out there every day of the year.

Continuing in this spooky vein, what is Microsoft doing now?

Witch Hat, or new higher trading range justified by the latest earnings release? Has the mother of all like-watching-paint-dry stocks finally become a tad less boring? [Hint: The premium is lousy, so it doesn’t matter.]

Watch out for all kinds of Witch Hats today, and happy trick or treating!

Tomorrow afternoon, Wed. October 31, the Fed’s Open Market Committee will meet and decide whether to again trim the FedFunds rate, which it cut 0.50% at the last meeting to 4.75%. The market is expecting a cut of 25 to 50 basis points, and if there is no cut, I expect a bit of volatility tomorrow afternoon. The market thinks the possibility of a recession is real, despite half-hearted assurances from on high, and a rate cut is needed to convince the market that the Fed is taking things seriously.

But I think the market will not be mollified by patter about inflation or anything else; it wants a cut. An article in the WSJ noted that the FOMC will either take no action or cut another 25 points. I expect a 25-point cut, because they can always cut again, but cannot keep changing it up and down, like Mexico. I don’t think the FOMC will ignore market concerns, but also does not want to signal undue concern about the economy, which a 50-point cut might do.

Be advised that the market could sell off if no cut is announced, and might sell off on anything less than 50 basis points. Some think the market sold off today (Dow down 77 points to 13,792) on anticipation of no cut or a small cut tomorrow, and if this is true, a 25-point cut may not provoke a sell-off.

Implications for covered call writers:

Anyone putting on a covered call position tomorrow should be prepared for more volatility and possibly another sell-off. If the market sells off tomorrow afternoon, consider buying a NOV or DEC put on long stock positions in order to take an extra profit from market volatility, closing the put on the pullback. Be watching the market tomorrow afternoon if you do this, since it sometimes gives head-fakes of a sell-off and then recovers. You can always sell the put.

The 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.

The market swooned today and then came roaring back, though it did not erase the entire pullback. Opening at 14,092, the market bottomed today at 13,904 but came back in afternoon trading to close at 13,984.80, making up close to half the drop from Friday’s close. So we finished the day down 109 points and change, which is only a drop of 0.73%. But like a football game that ends as one team is driving to the goal, had the market close been slightly later, the market would have recovered much more of the lost ground, maybe even have gotten flat. Clearly, Mr. Volatility has come to live at our house.

The ostensible reasons for the drop were 1) Citigroup’s earnings report, and 2) $86 oil. Amazing. The market was perhaps expecting glowing news from Citigroup, the largest bank in the country? And did higher oil catch everyone by surprise? Oil companies like Exxon (XOM) and Tesoro Petroleum (TSO) were up today, not surprisingly. And even Citigroup only sold off 1.7% by day’s end.

The correction is I think officially over. But market volatility is not. Everyone is gun-shy, which is why these volatility days occur. Traders rush for the exits to beat bad news sell-offs, which exacerbates the sell-offs. But the market came roaring back, because it’s still a bull market. So the only people hurt are those who panic and sell when the market experiences a volatility down day. These are delightful days for traders buying calls and puts on the market.

Black Gold, Texas Tea
Get ready for $100 oil. Not tomorrow or next week, in all likelihood. But articles have begun appearing in the WSJ and other respected sources, ruminating about how we will handle $100 oil. They have all concluded that we will muddle through. And they’re right; the republic won’t fall. SUV sales have remained strong despite rising oil prices and growing environmental concerns. But that is not my point.

The point is that the powers that be are starting the process of preparing us for $100 oil. Not that I didn’t expect it. Every force we can think of is pushing oil higher - lower Arab production, sharply rising 3rd world consumption; you name it. Russia turns out to have vast reserves, but don’t expect them to flood the world with cheap oil. Like I said, get ready, because it’s coming.

Stock and Covered Call Positions

It is important that stock investors and covered call writers not get panicked by these volatility days. Selling positions at a loss on a simply down day like today hands investors a completely needless loss. In fact, down days like these are perfect for establishing covered call positions: down stock + down market day. When the market snaps back, it gives a nice profit. In fact, this is a perfect time to write out-of-the-money calls.

Covered call writers who want to add some zest to a position would buy the stock on a day when both stock and market are down but only write the call when the market (and the stock) snaps back. This gives a jet boost to the position.

Don’t view market volatility down days like this as irksome problems; see them for what they are: opportunities. But even if that seems too rich for your blood, don’t let Wall Street pick your pocket by taking a loss on these down days.

Today’s post will take a look at a very popular stock from the viewpoint of one selecting a trade for covered call writing. Blackberry-maker Research In Motion (RIMM) is on quite a roll, closing at $113.87 on Friday, October 5th, pushed by an excellent earnings report on October 4th. RIMM appears on CallWriter’s Nasdaq 100 list for October and November, offering some nice flat returns:

OCT 110 Call $6.15 = 2.5% return (13 days)
OCT 115 Call $3.50 = 3.2% return (13 days)
NOV 110 Call $9.60 = 5.9% return (43 days)
NOV 115 Call $7.00 = 6.6% return (43 days)

Though the November returns are nice, the October returns offer a rate of return far higher. But how to judge RIMM from a call-writing perspective? Fundamentals rule, so let’s start there.

RIMM is highly profitable currently due to the success of its smartphone product. Earnings recently reported were approximately double the same quarter last year, yet they only dropped the P/E ratio to 74 (MSN), versus about 24 for the industry. The blowout quarter aside, though, earnings growth has not been great and earnings are very uneven, which keeps it from being considered a great company. Price to sales is about 8 times the industry average, price to cash flow 3 times the average. This puppy is very overvalued.

Fundamentally the company is strong, with A grades for growth and profitability, and MSN’s StockScouter gives RIMM a 10/10 rank, rating risk fairly low in relation to the stock’s expected return. Six months ago, it’s SS rank was 5/10, and the current change is due in large part to recent earnings, which may not continue.

Historical volatility (30-day) has been running about 50-57% (10-day is 64% due to movement on earnings release), which is not unusual for a mid-cap company, and implied volatility is about 45%; IV was higher before the earnings report, but after the release IV has fallen. The IV level basically is in-line with historical volatility; when it is significantly lower, we are not being paid for the stock’s actual volatility, remember.

Liquidity is good, with over 1,000,000 shares daily traded and over 25,000 open interest in each of the call series (yow). Speculators adore this stock, and with good reason.

Technically, the stock is in a strong uptrend and in the last few days spiked up strongly on the earnings report. In fact, the stock is right at its 52-wk high of $114.76. Whether RIMM can hold the price spike remains to be seen. Financial institutions are selling the stock quite heavy, indicating their view that RIMM has topped. Should future earnings not be so bright, RIMM will sell off, and certain institutions obviously are determined to avoid the rush. Given the high overvaluation, how much higher can RIMM go? That is hard to say, but it has traded with a P/E over 250.

VERDICT: RIMM is not a conservative write, due to the overvaluation, price spike, the uneven-ness of earnings (and possibility they won’t be repeated) and lack of steady earnings growth. I am not a fan of high-technology companies, but they have performed well in 2007. Since earnings were just reported, the next report is three months away and not an immediate risk. But the risk of a sell-off in the short term is definitely there, due both to the extreme overvaluation and the price run-up. RIMM is heavily written, among our members and others, and has produced stellar covered call returns this year. Since it normally packs good call premium, it is a perennial favorite.

The SuperPut strategy could be considered for RIMM. Here is how two selected protective puts compare:

Mar-08 110P $12.55 (cost = $2.09 per exp. month) 6 months
Jan-09 110P $20.40 (cost = $1.28 per exp. month) 16 months

By comparison, the NOV 110P is $5.70. RIMM carries a high premium as a normal thing due to its volatility, making it likely that the stream of premium income will yield a nice profit over the life of the put. A continuing runup in RIMM would make the protective put less protective as the stock rises, however, assuming that the writer is called out of RIMM and re-buys it or rolls the calls up with the stock’s rise.

I hope this is helpful. Don’t hesitate to leave a comment!

It almost gets old talking about it - almost. The week before the July 19th beginning of the market correction, I stated in this blog that it was about time for a major correction and that in fact a correction would be desirable and healthy. So when the sell-off began, I was not concerned. That’s what markets DO. When a market, or stock for that matter, goes too far up without a correction, I get very antsy. I want to see the steam blown off. And sooner or later, it always happens. Through August and September, I waded through dozens of articles in magazines and online speculating about whether the bull market was over and a new secular bear market had begun.

The Dow crossed the 14,100 mark yesterday to new highs and settled to close to 14,087. Can everyone breathe a sigh of relief now? Gosh, just a few short weeks ago the Dow was at 12,500. It’s easy to crow when you’ve read the market right, but it also illustrates the adage (spelled out best of all by Larry McMillan) that in order to profit, we have to predict something. We all of necessity form an outlook about the market and specific stocks. We are only human and that is all we can do, but traders and investors must do it in order to function. And when we form an outlook we should stick to it, unless the facts informing our views change.

Where the market will be tomorrow, I don’t know. Or next week. But larger movements in markets are usually predictable to a degree, barring the inexplicable event like 9-11. There are no guarantees, of course, and it is just possible that a new bear market had crept up on us. But while that was possible, I stuck by my guns, not out of stubborness (death to investors and traders) but simply because the facts underlying my market assessment had not changed. Every one of my blog articles stated unequivocally that 1) the market was only correcting, but that the correction would be a big one, because a huge asset/credit bubble is ending, 2) the market would rebound to new highs [done], and 3) that the bull market would have legs for a while longer. I still stick by those sentiments.

Until consumer spending - a huge component of the US economy and thus corporate earnings - falls enough to start degrading earnings, the market should prosper. But the housing and other woes will start to tell on the economy, so sometime next year, perhaps in the spring or summer, I expect this bull to fall from exhaustion.

My point isn’t that I was right, though. It is that I formed an outlook and acted upon it. Had the facts changed, I would have changed my opinion. The wrong thing, though, would’ve been to panic from reading the many articles stating that a bear market had begun and to get out of equities.

But enough beating of my masculine chest… what now?

COVERED CALLS:
As I have also stated many times, now is the time for covered call writers to focus on the large-cap stocks. The internationals are best, since their global cash flow tends to even out local quirks. I am not alone in this. John Mauldin and many others hold the same opinion. As a bull market gets long in the tooth, there is a flight to quality (large-caps) that causes the blue chips to outperform the overall market. The smaller and mid-size stocks will not - as an asset class - perform as well as, much less outperform, the large caps from here on out. Market managers increasingly are rotating out of mid-caps into large-caps.

This is where covered call writers should be. For CallWriter members, look first to our S&P 100, Nasdaq 100 (the large-cap technology sector is doing quite well), and S&P 500 lists. If you are not a CallWriter member (huh?!), then stick to those indicies, however you find trades.

Let’s make some money!

I predicted this market correction a week or so before it happened in July, which subsumes the fact that I consider it a correction - meaning that the market will find the July highs again and go on to higher ground. I’m not always right, so it feels good. 336 points on the DOW today; biggest one-day gain in five years or so.

To recap, I’ve been saying for a while that we’re in the waning stage of a bull market, that a correction was due, that the summer sell-off was a correction only, and that the market will recover to the July level and new highs. Sometimes we really have no clue what comes next, but - love me or hate me - I was rock-solid on this call.

So we recover; but then what?

The bull doesn’t have a whole lot farther to run, that’s what. I’m guessing the stumble will come by next summer, if not sooner. Like a doctor examining a terminal patient, I cannot say the date, but like the doctor, I have no doubts, either. With nearly five years under its belt, how much longer can the bull run, with a global credit crisis occurring and housing dragging our economy down further by the day? I’ve written about this extensively, so I won’t regurgitate it here.

I get emailed newsletters DAILY urging me not to panic, not to lose faith in the market, that the powers-that-be have the potential economic crises well in hand, and that the market will go on to incredible new highs. We’ll see some new highs, yes (barring the other economic shoe dropping too soon), but the market’s end is in sight; get serious. I’m not selling this blog or any newsletter, nor do I market hot stock picks, so these are my actual, unexpurgated thoughts. It’s not about faith or reading the tea leaves, it’s about applying common sense to the data.

When corporate profits start to falter, the market will go bearish for real. Actually, the market will turn south before the cascade of bad earnings, because certain forces always are, shall we say, ahead of the economic curve. But even these “forces” don’t know the “date.”

If you were on the fence whether we’re just having a correction or the bear market had begun, does the resurgence of the brokers like Lehman (LEH) in the last few days provide any reassurance? They have some of the largest credit-crunch and mortgage-meltdown exposure of any, other than mortgage and directly housing-related companies. Yet the brokers are soaring. This would not be happening if the bull were not getting back on its legs. Even Lowes (LOW) and Home Depot (HD) have been showing strength lately, not exactly a bearish sign for the near term.

I know, sigh, we had an artificial boost today from the FOMC, and the Fed can’t cut rates every day. But the market wants to go back up, and this provided a terrific morale boost. The bets placed on a rate cut are winning big.

We’ll probably have a hiccup or two on the way back to the market top, but I am bullish now for the medium term. The market may pull back again one or more times on the way back uptown, and I won’t panic if it does. The market usually surges in November (Halloween Effect), and may well surge earlier this year. Even at new highs, expect a lot of volatility - think of it as lots of chances to trade the calls!

TRADING:
Covered calls have been tough in the last two months for straight writers, though not bad for those adept at trading calls. But better times are a’coming. I think it’s about time to get long, actually. Buying calls or writing covered calls will work for a while yet, as will naked puts. In fact, OTM covered calls should be very productive in coming months as the market gathers its last strength. However, the real gainers, the safer stocks, are the large caps.

If you are not a well-practiced covered call writer, stick with the S&P 100 and Nasdaq 100; or at least the top half of the S&P 500. Quality, quality, quality.

Covered writers and naked put writers should in my opinion avoid small caps and all but the strongest mid-caps with the least exposure to housing woes, because if they fall it could be hard and fast. The market is cutting these stocks VERY little slack any more. A few will be great, yes, but you’d better be able to pick them. You will have a greater comfort level with covered calls on these if buying a cheap, long-term protective put.

The big brokers Morgan Stanley (MS), Lehman Brothers (LEH), Bear Stearns (BSC) and Goldman Sachs (GS) all report earnings next week for the quarter. Merrill Lynch (MER) reports in October. These are all important players on the world financial stage. Their financial results will be a good barometer of how bad the credit crunch in past months actually has been. Bear and Lehman have the most exposure to the credit crunch, since they rely more on fixed income sales, which means they heavily sold collateralized mortgage products, but all of them have substantial fixed income sales. The merger and buyout deals generate gigantic fees for these chaps, and the deals have slowed to a crawl as a result of the meltdown. Here’s where the brokers stood as of 9/7/07:

MS - 62.50, down from 90.00 (-30.5%)
MER - 73.20, down from 95.00 (-22.9%)
GS - 179.00, down from 233.00 (-23.1%)
BSC - 105.00, down from 172.00 (-39%)
LEH - 53.00, down from 86.00 (-38.3%)

Several hedge funds have collapsed, notably two run by Bear Stearns. Even Goldman had to pump $2 billion of its own money into one of its big hedge funds after losses in August. Brad Hintz of Bernstein Research (and former Lehman CFO) notes that the big brokers have substantial exposure to subprime because they securitize mortgage loans by cutting them up into tranches and selling the tranches. But the brokers wind up having to take the riskiest tranches that are exposed to the first losses (growing, and they will become gargantuan in 2008), known as residuals. BSC, LEH, GS, MS and MER have as much as $11 billion of these “residuals” on their balance sheets. They also get stuck with leveraged notes and other assets that no one wants now, because one of the ways they get underwriting deals is to take the paper and gamble on being able to resell it.

The market is waiting to see how much effect the crunch will have, how much their asset holdings (which are marked to market) will be devalued, how recent volatility has affected trading profits (they should be up) and how much the slowdown in M&A activity has hurt profits.

Many financial pundits are starting to say that the big brokers are so devalued that they are bargains. Maybe so, but they may be more of a bargain after next week… unless you think they have not been affected by the sheer immensity of the summer’s crunch and the fact that some of their most profitable activities have been virtually stopped dead in their tracks.

Trading and Call Writing
There will be lots of people shorting these stocks (many already have), though it may not be easy. When short interest gets large enough, where will you find stock to borrow? But even your Aunt Mabel can buy puts or place a bear put spread.

Anyone with a covered call on these stocks and who has not purchased a multi-month put to protect the position might consider doing so. Putting a covered call on these stocks requires such a put at this point. If the stock pulls back and catches support convincingly, the put (which will have increased in value with the stock’s drop) can be sold at a profit. Or the put can be exercised if necessary. Unprotected covered calls simply will have to ride it out, although the calls can be traded with the stock’s movement to produce trading profits.

These brokers are some of the most important financial companies in the world, so they are unlikely to vaporize. Bear Stearns is the greater risk and has been scaring people, Lehman is the next most likely to take a large hit. But the problems affecting the brokers are not resolved and not at a crescendo yet, either.

Stock futures are down this morning before the stock market’s open, signalling losses today in the stock market. S&P 500 futures declined 5.7 points Nasdaq 100 futures declined 11.75 points. Dow industrial futures fell 39 points. This may not signal a triple-digit pullback in the market, but today is extremely unlikely to be anything but another down day, unless news comes out that moves the market.

For those of you playing volatility, today might provide a chance to profitably close bearish positions recently put on, and you might be able to put them on this morning (buy puts, etc.).

Covered call writers: be alert for a chance to close short calls profitably if the underlying stock pulls back with the market.