The Dow Jones Industrials, after behaving badly and rather wildly, since early May, seems to be regaining its footing. Better news from Europe, China cooling to a still-torrid but more sustainable growth rate, US earnings coming in strong, the prospect of plugging the Deepwater leak - all play a part, no doubt.

Note in the following chart that the Dow has:

1. Broken above the (red) downtrend line.
2. Broken solidly above the 20-day and 50-day averages.
3. Now broken above the 200-day average.

It closed above the 200-day on Friday last, and remains above it. This is no assurance that the troubles are over. The Dow needs to close strong today. A close above the June resistance level is necessary for us to have any confidence that the correction is over. The head-and-shoulders pattern that I worried about earlier was not confirmed, but I will breathe a sigh of relief once we take out the June pivot high.

I am guardedly optimistic. Most covered calls written in early June or early July would have worked fine, assuming the stock showed the same or greater strength than the market. And many did.

The market remains news-sensitive, but that is the nature of the beast now. I will wait a few days before putting on any trades just to see if the market chokes at the June resistance levels.

Housing starts were down 5.8% compared with June 2009, and were down about 76% from the peak in 2006. Starts were down 15% in May, 5% in June, so the drumroll continues. Builders rushed to complete houses for the June 30th tax credit deadline, but that little pop - if pop it was - is gone now. Homes under construction also fell. Building permits were up slightly at 2.1%, and inventories of unsold homes stand at 40-year lows.

However, starts of single-family homes fell less than 1%, the lowest drop in 13 months, which is good news. Well, it’s better than worse news. Starts of multi-family units was down 22%, reflecting the glut in those properties.

Reflecting how far the futures were down pre-open, the market dropped like a set of keys in the first few minutes of trading today. Then it spent all day working its way back, going positive in the late session, and the DOW Jones Industrials (INDU) closed up over 75 points, less than a 1% gain. The S&P 500 (SPX) did a little better, up over 1%, and the Russell 2000 (RUT) gained nearly 2%. So the strength today was not blue-chip but in the smaller companies.

The DOW closed just a few points off the day’s high, and the SPX and RUT closed just a hair off their respective highs. This actually is pretty bullish, all things considered.

Don’t uncork the champagne just yet, though, because the initial jobless claims will be released on Thursday, July 22nd. I’m not putting on any long trades until I see how the market reacts to the jobless claims.

Remember that we are in the earnings season, and it is not wise to write covered calls or naked puts across an earnings release.

The stock market opened up today, after yesterday’s stunning rally of almost 275 points on the Dow Jones (INDU). Today’s action so far has remained positive, but it doesn’t have much steam, and is losing steam going into the late session. Weird things can happen these days in the late sessions, even the last couple of minutes. So what is happening, really? The market has been quite oversold, though the RSI was only at 30.6 for the INDU a few days ago and is now at 44.2. I suspect that a lot of the buying has been short covering, but it is not very oversold today! The last couple of up days also occurred on so-so volume.

A brief rally does not a bull market make, and my July 6, 2010 post about a possible head-and-shoulders formation on a weekly chart still is relevant. The market could, in a day, gobble up the last few days of gains. A European banking collapse, on top of US woes, could literally send the world into a recession, and the players who drive markets are afraid of being on the wrong side of it. As bad as the Wall Street bankers have been for the world economy, it appears that the Europeans were just as careless and profligate if not worse. Thus a lot of big buying is on the sidelines, including Ma and Pa, which is buy there is no real buying. On the other hand, if there were no buyers, we would already have broken the March 2009 low. God, any buying at all rocks this market.

Still, the weekly H&S pattern that I fear has not yet confirmed. Every market email I get, without exception, is bearish. They all warn us not to buy this rally. Since I am by nature a contrarian, this bearishness is the only ray of sunshine I can detect. In other words, I would be more nervous if people were smugly hooting that this correction is over.

So how do we covered call and naked put writers make money here?

The first way is to write those companies that are rising as the market falls. And they are almost always to be found, when the market is not collapsing. Look at FLIR Systems (FLIR) as an example. It started rising on June 10th in the face of a market selloff, and still is rising. The reason is that people want to own it. It is a top green stock to own, with a forward PE of 17.4 and a history of consistent earnings growth. There are others.

Such stocks are easy to find on our Real-Time Lists of the highest returning covered call and naked put trades. That is how I found FLIR - on our list of $20 to $40 Stocks, and it only took a few minutes. There was nothing good on the S&P 100 and S&P 500 lists! So, it took about 5 minutes to find it, and another 10 minutes or so (tops) to determine how hiqh quality it is. This works, try it.

Those who like to write ITM calls should focus on this method of writing, finding stocks that people still are buying despite the market volatility and uncertainty.

The second way, when the market is selling off, is to buy the Bear ETFs, which move inversely to an index, a sector or industry. These work best when the market is actually falling, not just down and not hiccuping, as it is now. If the market starts falling again, the Bear ETFs will shine. They are quickly found on CallWriter’s Real-Time Specialty ETF and Ultra ETF lists. I don’t doubt that readers get tired of hearing about this, but it is how we covered call and naked put writers make money when the market is puking up, and it is easy.

Writing ITM calls does not work so well on the Bear ETFs, because many of the sharp market downthrusts don’t last that long. We frequently get 5 to 8 down days, then a spike up, and that spike can force an ITM writer to close for a loss. Thus, the Bear ETF trades are short-term ones, a few days at most. It is not usual to pull a few percent out of one overnight.

Caveat:
In these degenerate times, I tend to do shorter-term trades, either writing OTM calls or not writing calls at all - just buying the stock or Bear ETF. My purpose is to catch short-term moves and get out with a few percent profit. I especially don’t like being long over a weekend. I’ll do it on a stock, but not a Bear ETF.

Ach, the poor markets cannot seem to catch a break. The major indices opened up nicely and rose for about the first 45 minutes. I expected a good move this morning since the Dow and Nasdaq futures were up smartly. However, as is so often the case lately, a strong open does not last, and down it comes.

I am concerned, as today’s newsletter issue evinces, that the market is making a head-and-shoulders formation on a weekly chart. The chart below tells the tale so far:

The chart does not reflect today’s price action. We are approaching the first Fib level, based on drawing the base line from the March 2009 low through the April 2010 high. We are just about 300 DOW points as I write from the first Fib level. Although not a very pretty H&S formation, the possibility certainly looms on the W chart, where it is much easier to see than on a D chart. Suffice it to say, we are testing the neckline right now. I hate these top-reversal patterns on a W chart, since the action tends to last so long once the pattern is confirmed.

No point in belaboring the obvious, since the tape will tell the tale. Between the oil spill, the European meltdown and sagging jobless and profits numbers, there is little reason to be bullish. The problem with the sagging tape most days is that buyers are staying away in droves. But at some point they will come back in. Where that happens is of course where the bloodletting will stop.

Working this Market

There are some good CC and NP trades to be found on CallWriter’s Real-Time lists, even in these degenerate times. The O&G service/equipment industry (BHI, etc.) seems to be turning around, with all of the major players being up. This is significant, since this industry has been down soooo long. But when an industry has had enough, it rebounds. Keep an eye on these stocks.

If the market selloff continues, write covered calls or naked puts on the inverse (bear) ETFs, which feature prominently at such times on our Real-Time Lists - look at the Specialty ETF and ETF Ultra lists. These really rock when the market is falling. We CC and NP writers no longer have to twiddle our thumbs when the market is melting down. They really work like a charm - so long as the market is swooning. If it firms up or starts to recover, they wilt away fast, so these are by their nature short-term trades; usually a week or less. Get in for a quick 5-10% return and get out. But the bear ETFs can deliver such a return in a day or two. Five down market days in a row is about all we get without an intervening white candle, so pigs get fat and hogs get…

ADDENDUM:
The market closed positive today after dipping into the red in the late session. I still don’t trust it much, and one tiny white candle (a tombstone doji at that) after 9 consecutive red candles does not exactly rev my engines. Still, there are some good stocks out there that will do well if the market doesn’t go off the cliff again.

Something else of interest. I have been telling CallWriter members for a long time about the power of the inverse (bear) ETFs when the market is swooning. I just got an email from the king of picks services (LN), touting a way to turn this market on its head and profit… using bear ETFs. Glad he discovered them! Maybe for them, with their multi-million dollar ad budgets, this is just a marketing pitch, but the bear ETFs (thank God for them) are a serious arrow in the quiver for us CC and NP writers.

A lot can be learned just from a visual scan of CallWriter’s Real-Time Lists, especially once the list data has been sorted appropriately. For example, a brief survey of our Global Select (Dividends) Lists is instructive today, after I sorted the list by Sector and then did a secondary sort by Industry (hold the shift key for the second sort).

I have had my eye on the Basic Materials (BMAT) sector, because much of it has been selling off recently. However, these sell-offs come to an end at some point, and I watch for that on our lists. For example, stocks in the same industry, or even the same sector, will show very similar MADI values - our MADI shows the stock’s current price in relation to the 20- and 50-day moving averages. A week or so ago, the BMAT stocks were showing MADI values of 00:00 and -01:00, indicating that they were testing the 50-day average and also testing or were slightly below the 20-day average.

These MADI values frequently herald a coming bounce off support. And voila! They are indeed moving. Agricultural chemicals aren’t really showing much strength, but AGU, MOS and POT all seem to be testing or maybe just resolving a test of support.

Gold miner NEM is showing a very promising bounce off support. GOLD on the other hand is frighteningly overvalued - a 90+ P/E!

Of course, chemical maker FMC is rocking, and never really sold off; it is a little stronger than DOW.

Independent oil and gas companies are showing some strength. Check out OXY, for example.

Much of the oil and gas group remains troubled. While BHI may be finding support, others such as DO, ECA and RRC are very weak. However, some of these stocks are fairly oversold and have the potential to bounce back soon.

There is no better time to put on a covered call or naked put trade than when 1) a stock has sold off in its trading cycle and 2) BOTH the stock and its peer stocks are recovering as a group. You can see this right on our lists, actually, once you sort by sector and industry.

Finding a great trade in a few minutes is rewarding, but sometimes we find “almost” trades that require resolution of a support test - and once we get it, vavavoom.

My post from February 17th opined that the market had gone into a retracement (of the July through January market rise), beginning with the selloff on January 20th. I won’t repeat those posts, but on February 5th the retracement hit what appears to have been its bottom and has risen strongly since.

Until this week.

Tuesday was a blow-off day, Wednesday regained the ground lost on Tuesday, and today the market sold off early on jobless data, but has recovered most of that by day’s end. However, trading volumes have been declining after February 12th, which means that the down days this week have occurred on falling volume - a bullish divergence.

My guess is that this week’s price action is just chart chattering.

Yo, covered call writers: when your covered call positions pull back with the market, be sure to buy back the calls. I do this if I can buy the calls back for 50% or less of their selling price. If the premium was large ($5 or more) I will pay even more to close, maybe 60% of the selling price; but no more. This percentage is based on the calls’ STO price, not the current market price!

Then I write the calls again when the stock snaps back. This is known as trading the short calls. The market has natural rhythms, like any living thing - all traders and investors are living, and thus the markets they create are living, also. For the market to chatter after a strong rise, like it did this week, is natural. Take advantage of it.

Have you closed your calls today?

Market Action

I won’t retrace my recent posts on the market retracement. But it would seem the correction is over. I would have preferred a little more of a correction, personally, but it is what it is. Even in these flaky economic times, the market tends to follow the rules. Today’s action was not spectacular. The INDU gained 43.4, the SPX 3.5 and the NDX 8.8 points. The Russell 2000 outperformed them all, a good bullish sign in my view.

Well, now what?

Now is a good time to write OTM calls or puts on great stocks, like those on CallWriter’s Global Select lists, providing they also are recovering along with the market. Why OTM? Well why not? The only justification for an OTM buy-write covered call is that you are short-term bullish. After all, you are getting less premium and less downside protection. Ah, but if the stock moves up you can close the trade early for a profit or let the trade be assigned at a nice profit.

This works just as well for naked puts, although the low delta means the put is slow to lose value and give you an early close unless the stock really moves. If really emboldened, consider a put very near the money. Though probably posing more of a risk - at least statistically - of assignment than OTM puts, they are more profitable.

In both cases, CallWriter members should use the Industry Rank link in our Research Page to look at the stock’s industry to make sure peer stocks are recovering along with your stock.

There isn’t much February premium out there, so look at March and beware of earnings reports.

Head Fake?

Wait a minute… what if this is all a head fake and the market starts selling off again? It’s not impossible. Just look at the last week of June 2009 for an example. If that appears to be happening, close the covered call position with the intention of getting into the stock lower. If short a put, close or turn the position into a put spread.

If you wait for all the technical confirmation even your Grandma would want, you’ve missed an awful lot of it.

Members’ Trading Lab

The evening of Thursday, Feb. 23rd there will be a Members’ Trading Lab for CallWriter members, 9:00 pm ET. The signup link appears on the members’ home page. It will be fun and very useful, so don’t miss it.

Everyone is aware that on January 20th, the market generally went into a swoon. This is no big deal from my perspective, and here’s why. Markets have to retrace periodically. After a period of uncorrected up (down) movement, the market periodically retraces some of the gain (decline) from the last correction bottom (top). The market shot up after the March 9. 2009 low and then corrected in June and early July.

Since that correction, the market had a solid advance without a serious correction. Note that movement within a trading range does not constitute a retracement. Real retracements (extensions, in the case of a downtrend) tend to give back 38, 50 or 62% of the uncorrected rise. On February 5th, the S&P came within 1 point of a 38% retracement, but the Dow didn’t come nearly so close.

So the question is, do traders believe the correction is over? In late January and early February the market advanced, only to sell of again. That brief advance clearly was a bear flag.

What about the latest advance off the February 5th bottom? It looks much like another bear flag, with lots of hammer candlesticks indicating sell-offs during the day and a close close to the day’s high. Today’s price action (1:45pm ET) as I write this is a large white candle on a daily chart peeking above (but just barely) the 20-day and 100-day everages.

On a weekly chart, the INDU and SPX both appear to be bouncing off the 100-week average on rising volume.

Today’s action seems to have moved higher than we would expect from a bear flag, so we may have seen the end of the retracement. I’m not putting on any trades today, because I view the market as being on a knife’s edge. I want to see a couple of solid closes above the 100-day average.

I didn’t like the looks of this market top yesterday and closed my remaining open position in Philip Morris (PM), for a 1.5% profit, better than a sharp stick in the eye. I’m at a 3.5% return on covered call trades for the month, not great but not bad.

The market has risen in its trading range since early November, rather sluggishly except for a couple of large candles, and may have topped out. I will be on the road to Tampa this afternoon when the market closes, and may not have a chance to blog further on the subject today.

The market has sold off this morning, although it rose steadily on a 5-minute chart from 11:00 to 12:30 ET, and now is tipping over again as I write this. The Dow Jones Industrials daily chart below shows how the market has been ranging. The red rectangles illustrate how the market has tended to congest at the top of the trading range:

But maybe not this time. If I had positions open, I would probably see how today goes and make a decision tomorrow. If today closes positive, that is a good sign for a little longer stay at the top of the range. If it closes down but not by much, that also is good, because the bears couldn’t keep the pressure on. If the market is close to the low later in the trading day, it might make sense to exit, but then tomorrow might be an up day, which is why I usually wait for confirmation.

If the market closes close to the low and opens weak tomorrow, I would get out, and look for a re-entry once support is reached within a couple of weeks, which will lower cost basis and set up a really nice profit. This works best with top-quality stocks, however.

Boy, this up-cycle in the range didn’t take long to unfold, and one reason is that the range is narrowing. Those who wrote ITM calls in early November are of course in much better shape, which is one reason they write them!

The market has been moving up from its late-November lows, as I foretold in previous posts. In retrospect, I was too conservative. And I am usually not that conservative. In fact, I usually get in once the market touches the bottom of its range on volume and starts to move back up - into stocks doing the same.

However, the market had broken out of its primary range in late October and tested the 50-day average. This made me want a little more confirmation that the market was in fact climbing back into that range. Too conservative.

Entering trades on Friday, November 6th would have been much smarter. And I would be in great profit. I put on several trades last week, and closed two today. I legged in to all three, meaning I intended to write calls higher, but closed instead. Here are the results:

11/9 - Bought Smith Int. (SII) @ 29.37, closed today 30.89, 700 shares
Profit: 1.52 (5.2%) $1,064

11/10 - Bought Caterpillar (CAT) @ 58.55, closed today 60.81, 400 shares
Profit: 2.26 (3.8%) $904

11/10 - Bought Philip Morris (PM) @ 49.66, , 500 shares, trade still open. Will close this week when profit sweetens up.

Had I written calls, the premium would have been negligible, and the profit much smaller due to buying back the calls. And so close to expiration, OTM calls are really losing time value - so every day the stock stutters is more loss of time value.

My trading-with-the-market approach works pretty well. It isn’t flawless, but when do covered calls make more sense than when the market is rising?

More on the market tomorrow.