Financials are taking quite a beating these days, not only price-wise, but also in the esteem of stock pickers, dividend investors, the buy-and-hold crowd and pundits alike. And for good reason. The brokers, banks and insurance companies are generally quite suspect. There is no way to know if another shoe (or a bag of shoes) will drop for any one of them.

Bear Stearns was in desperate straits - though well known to the industry - long before we of the public knew. Banks are exposed on subprime, Alt-A mortages, contruction financing on projects that are going to be slooowww sellers. Many large and regional banks, if forced to value assets properly, would have to close their doors. Regulators are looking the other way, and have no choice, in order to give the banks a couple of years to raise capital and outrun their current problems. Insurance companies also have exposure to many of these things. We have a severe information deficit about the financials in general. You and I have no way to know the true extent of these companies’ woes. At this point, I view an investment in most financials the same as diving into an unknown lake - we have no clue where the stumps are, or how many.

As if all this weren’t bad enough, the market has zero tolerance for mystery or goofiness in financials. A financial will sell off on the slightest whiff of negative news - even if not about that company directly and even if not particularly applicable to it. Unless you are intimately familiar with a company, it is healthy and not cutting its dividend, tread carefully. I do have a couple of suggestions below.

While some stocks like Wells Fargo are being touted as recovery plays, I definitely would not go long the stock without SuperPut protection. If truly convinced that a financial has been knocked down to a fire-sale bargain price level, consider instead buying an OTM (cheap) call with an expiration perhaps 3 to 6 months out; or whatever time frame you envision. If the stock recovers as expected, you’ll profit immensely. If it does not, you’re not out much.

Trading Possibilities:
Perhaps it’s one of those fractal things, but every rule has its exceptions, and there are a few good financial stocks. Here are a couple, both of which recently increased the dividend and are not beset by many of the problems afflicting most financials:

Bank of Nova Scotia (BNS) - This Toronto-based megabank operates well over 1,000 branches outside Canada and make a lot of money. It has seriously outperformed its peers and the S&P 500 since 2002. And since 2003, it also has increased revenues, earnings and dividends, with revenues, earnings and dividends expected to continue increasing in the future.

BNS has been falling of late, like most things. It’s no surprise that a financial would have been whacked recently with the market. Technically, the price has touched the 200-MA on a weekly chart and is clinging to the 50-wk average. If if breaks back above the 50-week average (which is also the middle of the Linear Regression channel), it’s a buy.

Banco Santander (STD) - this highly profitable Spanish bank has increased its dividend significantly since 2003, growing revenues and profits as well, and since 2004 has beaten the snot out of both the Large Bank industry and the S&P 500. Technically, it’s at the bottom of its trading channel on both daily and weekly charts…

As Yogi Berra said, you can look it up. Translation: do your own research.

Today is expiration Friday for the June 2008 equity options (tomorrow, Saturday, is actual expiration day). If you are short ITM options at or close to expiration and do not want to lose the stock, meaning have it called away, here are two techniques that allow you to keep the stock:

1) Buy back the short ITM calls, which will be down to parity (trading at intrinsic value) or close to it. If the stock has advanced, this is an expensive prescription, because the call’s intrinsic value will rise with the stock price. But this is a poor practice, because it adds to the cost basis in the stock. In other words, the stock price will be below the position’s cost basis. The only justification for closing ITM calls is an expectation that the stock will rise in the short term, recouping the cost of buying back the calls. If the stock pulls back, the stock will be below cost basis. Thus closing ITM calls should be reserved for those instances in which you have a short-term bullish outlook on the stock.

As a side note, the market may well have bottomed temporarily, as noted in my most recent issue of the Money Newsletter. If so, good stocks will be rising in the short term. Weigh this alternative with the one below.

2) Roll the calls out to the next month, meaning to buy back the short ITM calls and sell calls of the same strike price for the next expiration month. Because premium will be higher for the next month, rolling up should generate a credit, not a debit. The roll out allows you to neatly skip over assignment this month and defer it. If the assignment is presented again at next month’s expiration, you can roll out again.

You may be able to roll up and out to the next month for a modest debit (I personally don’t add debits unless they are nominal) - or roll up and out two months. In a strong bull market, this may make more sense, because stocks can rise for a long time without a meaningful retracement.

A frequent question I get about rolling out is: isn’t it just deferring the inevitable? Not really. Remember that YOU choose whether you are assigned or not. If we posited that the underlying stock will keep rising forever, then rolling out would indeed only postpone the day of reckoning. But that does not happen. Sooner or later the stock will retrace and give a breathing space to close the short calls. In a volatile or bear market (like the one we have now) a pullback is pretty much assured.

If you roll out, you can always close the new calls - that option always is on the table.

I rarely publish a blog article that merely points readers to another blog or online article, but this one by Herb Greenberg in his MarketBlog for MarketWatch.com is worthy, with Bear Stearns at the crisis point of failure, and others perhaps not far behind.

When you deposit stock in a brokerage account, or buy shares in your account, the shares do not go into your name but into the broker’s “street” name. Many times they are depositied directly into Depository Trust Company, in which case they are held in DTC’s street name, which is Cede and Co. Although the stock is beneficially owned by you, title to the stock really is in the broker for your account.

In other words, ownership of your stock becomes legally split, as in the trust situation. In simple cases, the true owner of a thing is shown (e.g., vehicle) as the owner on the instrument of title (e.g., vehicle title). But in the trust situation, the trustee holds legal title for the benefit of the beneficiaries, who actually own the thing in trust. Stock held in street name by the broker is analogous to the trust situation. Your stock is held in a pool of stock by the broker in the broker’s name, not yours.

If the broker goes toes up, you merely become a creditor of the brokerage, with its assets distributed first to creditors, then ratably to customers. There is no good fix for this, since brokers simply cannot hold securities in your account in your name. The only other alternative is to have the securities held in a trust bank, as explained by Herb and his colleague in this article:

It is worth reading. Make sure your broker is solvent with not much subprime exposure.

As I (and others) predicted yesterday, the market sold off today. The DOW closed at 12,099 on Friday. On a weak open today, it swiftly sold off 460 points to 11,634 and is fighting to hold on to the 12,000 level. There were a huge number of sell orders from around the globe this morning, so the market was bushwhacked.

I remain short-term bullish; short-term only. The market should recover some of the lost ground, but this will only be a bear rally. The medium- and longer-term prognosis is not good. Don’t depend on the election year to save the market. I am not counting on the market to recover today, but it may begin a short-term recovery this week.

Some thoughts for covered call positions:

A lot of covered writers are in impaired positions. However, if you write covered calls on a market rebound, you will be caught in the assignment trap - forced to be called out at a loss or repurchase the short calls as the stock rises. It is usually better in this case to simply let the stock recover. If you are short calls at a strike below your cost basis, consider closing the calls and letting the stocks recover with the market.

When a stock recovers enough, consider taking profits on covered call positions or turning them into SuperPuts by purchasing the long-term puts, where the puts are cheap, with very little time value. It is advantageous to construct the SuperPut at a higher level. By example, if a stock ranges from $100 to $110, it would cost a lot to buy the 110P when the stock is $100 - we would pay $10 in intrinsic value, plus time value. But when the stock rises to 110, this is the time to buy the 110P, which offers far more protection.

Implied volatility being about the same, it will cost about the same to buy the 110P when the stock is $110 as to buy the 100P when the stock is $100. So it makes more sense to add the long put at the higher stock price. This is why I am more inclined to establish the SuperPut at highs, at range tops.

On the other hand, puts get pretty expensive when a stock is falling. We pay too much time value then due to high implied volatility. And when the stock stabilizes, the IV evaporates, diminishing the put’s value. A big key to the SuperPut strategy is not overpaying for puts.

If the puts are expensive (more than 2% monthly), it might be better to find another stock. As the stocks fall again with the market - and they will - the long puts will make it possible to write calls on the stocks (and close and trade the calls to generate additional credits) with impunity, since the long put provides a price guarantee.

I look forward to a brief market recovery and to establishing all SuperPuts at the higher price levels. Don’t be discouraged or freaked out by the market volatility. We are about to be in a terrific position to place SuperPut trades and laugh at further market decline, because the long put will make falling stocks someone else’s problem.

Yesterday (1/3) I put on some trades, since I like to write on market down days. I didn’t know today would be another market sell-off day, but who did? I want to do more this year of sharing my trades and thought processes with you. I won’t always be right, any more than you, but my goal is profit, not glory. I want to discuss one trade in particular: Amazon.com (AMZN):

I’ve done well with AMZN - it has been berry, berry good to me. The more I think about etailers, though (and AMZN is the big dog in etailing), the industry is a bit overbought, with a P/E over 100. So when the stock dipped today with the market sell-off, I decided to roll the calls down and out. I bought back the JAN 95C (-1.97) and sold the FEB 90 Call (+8.15). This lowered my cost basis to $86.02 in a stock that cost $97.00. Thus if called on the FEB 90C, I make roughly $4.00 a share, or 4.3%.

FEB expiration is on 2/16, which is 42 days out. If called, my return will be 3.1% normed to a month [4.3% / 42 days x 30-day month). This means that absent further selling off I will make a return that is at least 3% per month. I’m doing several contracts, so trade costs are minimal.

Should I have rolled down? Well, AMZN has started to come back a bit, but who knows? If there is bad news, I will be happy for rolling down-and-out. If it snaps back, I will not cry about leaving money on the table. 3% a month is not bad where I come from, and I’ll take it happily.

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!

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!

Implied volatility (IV) is the level of stock price volatility implied by an option’s price, expressed as a percentage. For example, 35% is normal rather than high, but 85% is rather high. An abnormally high option price suggests - but does not actually forecast - imminent higher volatility in the stock’s price. There are three main reasons why premium and therefore IV get high:

Covered call writers love high-premium plays, but we have to pay attention to the fact that premium is high for a reason. Since IV just might be high because of impending news, and that news could be very important, it pays to look for news. Searching out the news is not an absolute requirement for covered call success, but the smaller, less established and less profitable the company is, the more important it is to track down the source of high IV.

Stick with established, profitable companies that are growing earnings – always the best bet for covered calls.

A CallWriter member recently stated that covered call writing takes too much time and can interfere with running a business. Actually, covered writing can involve huge amounts of time, or very little time. It all depends on your objectives and your approach.

The two areas that involve time and effort in covered writing are research and monitoring trades. Research in order to find the best stocks with high call returns can take time, since the research is our best protection against stock failure. We monitor trades partly in self-defense but also partly to look for opportunities to close the trade advantageously or simply to trade the calls. Trading the calls (buying them back cheaper than they were sold and then selling them again as the stock moves back up) can really add to returns, but it is not necessary in order to succeed at call writing. Many covered writers let their trades go to expiration regularly, closing them early only every now and then. And there is nothing wrong with this laid-back trading style.

Milking every possible penny out of trades requires watching them and trading the calls as opportunity presents itself. This obviously takes more time than simply writing calls and checking open trades once a day or so. But active monitoring is not a requirement when you write only the best companies.

For those unable or unwilling to monitor trades frequently during the day seeking transient trading opportunities, there is an easy way to write covered calls that involves fairly little time. Simply stick with S&P 100 stocks that are profitable and growing profits. The preferred method is to sort through the stocks on CallWriter’s S&P 100 list to find a group of candidates you like that frequently have high premium and therefore are frequently on our lists (ideally in different industries) and concentrate in them. Or you might like stocks such as Dell that have already taken a hit and formed a new trend or trading range. Doing this cuts down significantly on research time, and the same thing can be done with our Nasdaq 100 list. Note: avoid the ones in trouble or whose chart shows the stock diving for the cellar!

Write ATM for maximum return, or write ITM for less return but a larger premium and thus more downside protection (not every ITM call will offer good return). It’s your choice.

Then simply let the trades go to expiration and, if not called out, either re-write the stocks following expiration or sell the stocks and find new trades from the same list and write them. This writing style works just fine, and the majority of covered call writers probably trade in this fashion - conservatively and laid back.