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.

It is a well-known fact that when a large, heavily traded company sells off for an extended period, a rebound usually is in the offing. I found a number of such potential candidates on our Real-Time Lists of the highest-returning covered call trades, and will share them with you here.

MOS/POT/AGU - all are testing the 100-day or 200-day (POT) average. POT reports earnings today, AGU on February 9th, MOS in April.

X - Steel has sold off like a runaway freight train. It does not make money, but technically may be ready for a heady (and not long-lasting) turnaround. It next reports earnings in April.

NEM - Newmont is oversold at a 30 RSI and accumulation is turning up. It is hanging on to the 200-day average and testing the 50-week average, but had huge climax volume on this test of major support. NEM reports on 2/25, after February expiration.

Confirmation would make these good for naked puts, also. Since we want to stay diversified, one should write only one of the MOS/POT/AGU group.

I caution that, since we make no wine before its time, confirmation of price recovery is necessary. I may very well play some of these with OTM covered call writes for February, but I want to see some recovery, and the market doldrums are pulling most things down. OTM writes give me low delta and enables a profitable close if the stock snaps back as expected. I can’t say I expect turnarounds in these just yet. We wait for turnaround confirmation in case they want to look for new lows.

The markets closed strongly today - well, not the inverse ETFs, chuckle. Today should be confirmation for even the most timid soul (me) that the market is in a new up leg after bouncing off support last week. Actually, today would have been a lovely time to enter covered call and naked put positions. For that matter, Friday would have been, also.

There always is this tension: get in when the market trend is the fattest (close to support), or get in with more confirmation once the rally back up into the trading range has “proven” itself. The former can yield more profits, the latter is somewhat more conservative.

I put on a trade in QQQQ again, both long stock and “other”. The CC trade was a purchase at 43.14; I would have liked to sell the NOV 46C, but the premium was pennies. So I legged in. I will either write calls at a higher level or simply close when an acceptable profit is presented. A 3% (raw) return suffices, but I will, ahem, accept more.

OTM is better, because the calls’ low delta makes an early close possible and very profitable. Getting a 5-10% raw return in doing so is not difficult. An ATM write works well and could be closed early, also, but the higher delta makes it tougher, and the return less. ITM should work well, too. Note that November expiration (21st) likely will come a little before the market and many stocks top out at the upper trend (range) line.

Great time for naked puts, too. Try to write a strike below the 20-MA, or if the stock is not above the 20-MA, below the 50-MA. Leave enough room that a typical (for the stock) wide-ranging day will not stop you out of the trade.

WHAT TO TRADE?

There are stocks that bottomed a little bit ahead of the market, with it and behind it. Those ahead of the market I will not touch, because I want a little more travel left in it. Here are some November trades that I like, all of which I would write either OTM or leg in:

SII Smith International - has broken back above the 50-MA, low premium, leg in
PM Philip Morris - has broken back above 20 and 50-MA, low premium, leg in
CAT Caterpillar - ATM 60, 2.8%, has broken back above 20 and 50-MA
BTU Peabody Energy - ITM 44, 2.9%, has broken back above 20 and 50-MA

There are others. Baker Hughes (BHI) just broke above the 50-MA today, well behind the market, and could also be a good trade in the next day or so. I found these by sorting for MADI, looking for stocks 00:00 or better, then doing a secondary sort for flat return.

These stocks came off our Global Select (Dividends) list, and none of these have earnings coming before expiration on November 21st.

I would set a stop, or mental stop, below the 50-day average - preferably below the lowest late-October close. We don’t want to be stopped out too soon on a wide-ranging day.

Good luck.

I hate making this post, but it must be done. After being up nearly 150 points today, the Dow Jones Industrial averages settled back for a close at 9802, just 30 points above yesterday. Other indices are looking as bad or worse: SPX, COMPX, NDX, RUT.

Chart 1 below of a few weeks of action on the S&P 500 illustrates my concern. Last Friday the market had a huge down day, the one marked on my chart as “engulfing candle?“.

Usually, a huge red candle like Friday’s after a several-weeks pullback signals a possible reversal in the opposite direction (North). But engulfing is as engulfing does. For that hoped-for reversal to happen, a series of rising white (positive candles) would be needed. The close of one of those white candles above the top of the engulfing candle would be the money candle! Note what happened at the August, September and November lows in the uptrend: engulfing candles followed by a series of up candles (the market went up):

Now, let’s turn attention to the three candles following Friday’s big red. Two advancing candles and then the long shadow. Today’s candle made a very long upper shadow than fell back to close almost at the day’s open, which indicates weakness. This could very likely be the “shooting star” pattern, which is bearish. These often show at the end of a move up. Is two white candles in a row enough of a move up to call this 3-candle pattern a shooting star?

We’ll soon know.

I don’t trade these candlestick patterns. I’m just trying to size what up is happening. I don’t know what’s next, anymore than you do, but price and volume are all we have.

Covered Calls and Naked Puts

Candlestick analysis is by no means foolproof. To paraphrase Ebeneezer Scrooge, they show us what may be, not what will be. But for now, unless and until we see more up candles and a close above Friday’s big red (which could also be a close above the 20-day moving average and back into the primary trend), there will be no entry signal for those who trade with the market.

Do not put on a covered call or naked put position now. Even if you are eyeing a stock that sneers at the market, its behavior could change if the market heads south.

A number of CallWriter.com members are long Amazon (AMZN) and short November calls and are feeling a bit trapped due to the stock’s bottle-rocket takeoff. Obviously, we have to be prepared to sell the stock when covered calls are written, because these things happen. What these members are experiencing is the regret that arises from thinking about all the money being “left on the table.” But it frequently is not left on the table.

One member, short the NOV 90 Calls, wrote to ask how to handle this situation. For those of you living just a little too far back in the deep woods, AMZN announced great earnings a few days ago. The stock gapped nearly $18 on October 23rd to open at $111.05 from all the orders piling up before the open. It has since hit a high over $125 and has pulled back to about $120 as I write this. The chart is the final authority, though. Note on the chart below the huge gap on 10/23, then the meteoric rise after that. Note also the spiking and then disappearing volume, and the exploding MACD.

Amazon looks to me as though it has to come down.

1) Notice that it has made a huge gap up from the 20-day moving average, which it will likely pull back to fill.

2) The trading after the gap is classic witch hat, meaning sharply up on just a few (two, in this case) candles, back down the same way.

3) This event happened on earnings, and the euphoria will burn off once all the buyers are in, which may already have happened. AMZN was thought to be a hot buy below $90; is it still? This is not Apple we’re talking about.

This price action does not appear sustainable, and my money is on the witch hat.

Naked Puts

If you had a naked put on before the 10/23 gap, you should close it, if you have not already done so. This locks in about as much profit as the position can produce and frees your cash for other action. If you wrote a naked put after the gap, CLOSE it. Your situation is not going to improve from here on out if my assessment above is correct.

Covered Calls

If you react to the price move – say, by rolling up, buying calls or buying a vertical call spread, all bullish modifications – you increase your capital committed to the stock, especially by rolling up. Rolling from the 90 Calls to the 120 calls would add over $30 to trade basis. Adding more than a few percent to your cost basis is almost never a good idea, and it’s no better an idea to chase a price spike like this one.

Make any of these mods and you become a bettor, betting the stock rises further. All three mods, in order to work, require the stock to keep rising. If it falls you would be hurt; and hurt badly, if you have rolled up and increased cost basis. When a stock delivers this kind of shock to a covered call writer, it is better to wait and get your bearings.

If you don’t want to lose the stock as expiration approaches, you can always roll the calls out to the next month and see if time and tide cures the problem. I will be very surprised if AMZN holds where it is for very long.