In recent posts I discussed, among other things, plays involving Allegheny Technologies (ATI), which just pulled back below its 50-day moving average yesterday (May 1) and recovered slightly today after opening right at the 50-MA. This pullback to support is a common thing for ATI in its uptrend, it’s just a matter of getting the timing right. Thus the coming pullback and bounce off support was a no-brainer, given the strength of 1) ATI itself, 2) its uptrend, 3) the metals industry and 4) the overall market. This was a duhhh play. We didn’t need news or to play earnings to cream a very strongly performing stock making a very obvious move.

Here’s a daily chart (click to enlarge) - I didn’t mark it but imagine the 50-MA close to the $108 level:

As ATI fell, covered writers were well advised to buy back short calls, since closing calls at a lower price than they were sold creates a profit. Or roll the calls down repeatedly. But as yesterday’s price dip illustrates, you have to be watching to catch some of these moves. Another good play I discussed was to buy the 105C when it bottomed, although I would expect the next wave in the uptrend to take it well above $120, so there is still room. Sure, implied volatility was high, making it expensive, but it was an excellent, high-quality play. If you bought the 115P or 120P as also discussed, you should have closed it out yesterday for a very nice hit.

I thought ATI would spend more time testing the 50-MA, and it still may come back to do just that, but sometimes great opportunities like this are transient.

BTW, this stock came off of our staid, boring old S&P100 list!

In the April 17th issued of my Money Newsletter (”When a Stock Pulls Back“), I discussed Network Appliance (NTAP) and Allegheny Technologies (ATI), both of which appear to be pulling back to a moving average or trendline. If you have not subscribed to the newsletter, you can still get that issue if you subscribe this week.

NTAP is $37.18 as I write and since December has moved around quite a bit, from the December high of $41.56 to the recent $34.69 low. This is quite a bit of difference over relatively short time frames, about 20%. Wide-ranging days happen but are not frequent, but wide-ranging weeks are not at all uncommon. This movement makes it possible to write ITM calls and buy them back more cheaply for a profit.

Covered call returns will be low when implied volatility is low, thus many would question the point in writing calls on a stock like NTAP if volatility is low. True, low IV means that a buy-write (to buy stock for the purpose of writing calls) is a poor choice for NTAP. But for those already long NTAP, writing ITM calls at a high point in a stock’s range of daily movement - and even better, weekly movement - creates a profitable call trade when the stock pulls back.

ATI is $114.94 as I write this. It can oscillate about quite a bit, also. Just today the low and high prices are $111.45 and $115.05, a $4.50 difference so far (yesterday even larger). It can easily move over 4% in a day, much more in a week. Days with $2.00 of movement in a trading day are not at all uncommon. I stated in an earlier post that ATI would in the near future pull back to the 50-MA, which currently is about $107.20, and then resume its uptrend. It keeps nosing closer and no doubt is heading there. But - you don’t have to wait for a pullback to the trend with cymbals crashing; you can make money on it all the time.

Unlike NTAP, ATI offers good premium. ATI in fact perennially occupies a top spot on our S&P100 list and normally offers good covered call returns every month. IV is high compared to historical volatility, and time value is excellent.

Thus ATI is a good covered call candidate, and savvy call writers are milking it like a cow. If putting that trade on now, I would probably write a May or June ITM 110 call in the expectation that it will pull back to the 50-MA, giving me a chance to close the short calls with a fine profit - maybe even close it earlier on another day like today. If you are short the 110 already, I hope you closed that call today and are writing it again!

In the last month alone, ATI offered numerous chances to write calls and buy them back at a profit. Think of this combination of fat time value and price movement as a gift from Wall Street. Traders all over are scalping these moves, and we should be, too.

When ATI resumes its uptrend, I would write it OTM a couple of months - heck, the JUL 120 is bid at $6.10. Or wait for a new price advance off of support and continue the tactic of writing ITM and closing the call on pullbacks. Take advantage of stock price movement when you like and trust the stock, meaning the company is solid. When the stock moves around and there is fat time value, too (ATI), you’ve got a heavenly combination.

How often should you scalp a stock? If it is possible to do once or twice a week, why not?

This is a follow-up to my April 9th post about Dendreon (DNDN), a pharmaceutical maker, or rather would-be maker, in which I noted an extreme price spike in the stock due to possibly favorable news on its Provenge drug in development. I speculated that the stock would not hold price and pointed DNDN out as a bad covered call play, but a good short, puts being too expensive. DNDN had spiked to $21.78 at the time of my post and later reached a high slightly over $25.

Of course, a bear call spread was a potential trade, too, or a naked call. See how one trader actually handled DNDN.

A CallWriter member tried to short the stock but found none available to borrow from two different brokers. He also found, as I suggested, that the puts were too pricey, but nonetheless bought the OTM May 17.50P and closed it for a .30 profit, not bad. When the market sees an aberrational spike like this, options get really expensive. They remain expensive as volatility continues, since people are willing to pay a big premium for options.

His big score, though, was writing the ITM May 20 Call for $8.20 when the stock was $24.35 (not too far off the stock’s high). He exited the call when it fell to $2.60, a pretty good score of $5.60 a share! Note that the call’s low has been $2.00 since the stock’s high, so he got most of the possible profit. Naked calls normally are written at an OTM strike, above a strong resistance level or at least above the stock’s apparent high-water mark, yet this trader sold a deeply ITM call with $3.75 of time value in the next expiration month. The trader’s real risk obviously was a continued move up in the stock. But the trader won if 1) implied volatility collapsed, even if the stock remained at that price level or pulled back only slightly, 2) the stock price collapsed (as it did) or 3) when time value eventually evaporated close to expiration (which certainly would have happened as expiration approached and the ITM call’s price moved close to parity), in either of these events enabling him to close the short call at a profit. Significantly, he sold a May call, which gave him time and room to operate; June calls were not then available and the April call might not have allowed enough time for a pullback or change in volatility.

In other words, the high time value - which would have been poisonous for someone buying the calls - worked in favor of someone writing the calls. Remember, buy low volatility, sell high volatility, and this is an object lesson in how to do it.

Note that someone not approved to write naked calls could have done a very similar trade by also purchasing a higher-strike call, turning the naked call into a bear call spread. However, the high level of implied volatility would have made a bear call spread less profitable, due to the high cost of the long call, even at the 30 strike.

This ITM naked call was a smart, gutsy play - and the trading was pretty icy. Good work, Barry!

This is probably one of the top three or four questions I get: when can early exercise (exercise before expiration Friday) of call options be predicted to occur? Of course, only calls that are in the money (ITM) will be exercised early - meaning the stock price is higher than the calls’ strike price.

ITM calls are as a general rule are only exercised early when expiration draws close and they are trading at or below parity - “parity” means that an option is trading exactly at intrinsic value with no time value at all. This generally happens in the last week or possibly two weeks before expiration; usually in the last few days. When there is time value left in the calls, it is more profitable to flip the calls than to exercise them and sell the stock. When the call’s price is below parity, exercise can be expected, and the further below parity the more likely exercise becomes.

Thus I don’t worry about early exercise until an ITM call gets close to or at parity. Even when parity is reached, though, the covered call writer has the option to close the call or to roll out a month (or up and out) to get more premium or avoid losing the stock, if desired. Covered call writers have a lot of say in whether they are called out or not.

Still, early exercise of ITM calls is never assured even when calls are trading below parity. But if open interest in the calls is high (meaning a lot of professional traders) when this occurs, exercise is quite likely.

This week’s Money NewsLetter for covered call writers discussed how to handle a stock that is pulling back to a clear support level, either a trendline or 50-day moving average - and noted how covered writers are free to trade the calls as the stock price moves around. What many covered call writers don’t realize when getting into the game is that we are not limited to selling calls once only!

Many stocks will oscillate in price, and when they pull back we can buy back the calls for less then we sold them - which creates a profit. Then when the stock moves back up, sell the call again. This is known as trading the calls and you can do this over and over. Look at the effect on your account, assuming you bought a stock for $20, wrote the 20 Call for $1.25, bought it back and wrote it again:

This is a simple example, but closing the call out at a lower price and reselling it when the call premium fattened up again on the stock’s snapback increased the return from 1.25 to 1.75, a 40% increase in the return. On stocks that move around a lot (swings of 1.00 to a few dollars intra-day or intra-week), the calls can sometimes be traded several times before expiration.

The amount that the call premium moves in comparison to a price move in the underlying stock is known as the delta. ATM calls have a delta of about 0.50, while OTM calls have a delta more like 0.30 (call premium would fall 0.30 if the stock fell 1.00). But ITM calls can have a delta of 1.00 or close to it, meaning that the ITM call’s price can fall dollar-for-dollar with the stock, or very nearly.

The covered call writer’s goal is to cream a stock for income by writing call options against it. The beauty of it is that we can trade those calls. Those who knock covered writing assume that we write a call and forget about it, themselves forgetting that covered call returns can be bolstered considerably by a little judicious trading.

A member this morning pointed out a trade on our Pharmaceutical lists of the highest-returning covered call plays: Dendreon Corp. (DNDN), a biotechnology company. On this morning’s April expiration list DNDN was shown at $21.78 earlier and it was possible to write the APR 20 Call for 2.90 in premium (5.1% return) and the APR 22.50 Call for 1.80 (8.2% uncalled, 11.6% called). Nice returns with only 12 days left until April expiration on 4/21. [The stock has moved almost 2.00 in the time it took to write this post, so many of the numbers in this post may be really old.]

But not so fast, let’s take a closer look.

After being essentially flat for two years and seldom being above $5 in the last year, this stock went up in late March like a bottle rocket, leaving anything resembling support (including moving averages and trendlines) far behind. There was a huge gap from about $5 to $12, and the last couple of days’ upmove has occurred on decreasing volume (although if volume continues at this rate, it might make a liar out of me), as the chart below shows:

(Click on the above chart to enlarge it)

DNDN moved up on an FDA panel’s endorsement of Provenge, Dendreon’s prostate cancer drug, although some have questioned the propriety of an FDA approval. Given the uncertainty of better news on this stock (and even with better news, does it have much further to go?) and the fact that it has spiked so far above support, it is a dangerous covered call write. See my archived newsletter on writing price spikes for more thoughts in this vein.

It is a small pharmaceutical company that loses money undergoing extreme current volatility, which breaks just about every rule of conservative covered call writing. The cost of protective puts for a covered call position is quite high, and the spread on the puts is enormous - the MAY 22.5P was 5.60 x 6.10 as I write, a bid/ask spread of 0.50. The stock is moving fast enough that it is hard to get option quotes consonant with the same stock price!

The stock may well not be able to hold this price level without more good news, like moving toward closer to FDA approval, which is uncertain. It may even fall on further good news in view of all the speculators who have already bought the rumor. I see this stock as a short - a straight put buy isn’t indicated because they’re far too expensive. Even the OTM MAY 20P is going for 4.90. Sell high premium, buy low premium, remember?

Speculators are having a field day. Putting a covered write on this stock is a real gamble. It might work, but your fingers will be crossed (and your knuckles likely white) waiting for April expiration.

Regarding the writing of dips (pullbacks) in a stock, here’s a great question from a CallWriter member that will make a helpful post, along with my response. The member asks, “I’ve made two trades already - one good and one not so good, but I think I’ve learned something I want to confirm. Both stocks exhibited uptrends and in my haste to get into the trade, I traded before the stock retraced to the 50 day MA. Both retraced, so now I’m wondering: is it better to wait and confirm strength of the uptrend as it bumps off the 50MA before making the trade?”

When a stock is uptrending you cannot know for sure when it will pull back. You can see points at which it likely will pull back to the 50-day moving average, assuming the advance/pullback waves come at the most likely points. Of course, they don’t always come precisely where we predict! Better yet is to buy and write the stock at a point where it has pulled back to the 50-MA support level, which is known as writing a dip (pullback). This technique allows an OTM write with a solid expectation of getting called out after the stock advances again after testing the 50-MA. Even if not called out at the OTM strike, the stock should be up after the MA test and you can rewrite it. You’re making a lovely return either way.

Alternatively, buy the stock on the dip but wait to write the call until the stock has advanced a couple of bucks, which brings in substantially more premium – this is the “legging in” technique.

Suppose a stock is moving up, hits 31.25, then pulls back to the 50-MA at 28.50. By buying the stock on the dip you can either write the 30 Call with a good expectation of being assigned for a nice return, or wait until the stock moves back up to, or past, the $30 range to write the 35 Call, which brings in a fatter premium than writing the 35C when the stock is at support.

Obviously, it makes sense to wait until there is confirmation that the test of the 50-MA is successful before buying the stock. This depends on your comfort level with doing technical analysis and your confidence in the stock’s trend.

But - suppose you wrote the uptrend already and now find the stock pulling back to the 50-MA. No problem! Buy back the short calls if doing so would yield a meaningful credit, then write another call once the stock has tested support at the 50-MA and moved back up. In other words, trade the calls in this situation. Stocks that move around present opportunities to trade the calls.

If you sold a call for $1.25, the stock pulls back to support and you can repurchase the calls for $0.60, you are picking up a $0.65 profit. Then when the stock moves back up you can resell the calls.

Remember that trend lines can act as support as well, and the best setup for this trading is where the trend line is the same as the 50-MA.

This post originally discussed a variant of a covered call strategy to be taught at my March 10/11 seminar, which has come and gone, so I have updated it to deal with emails received. Comments generated were eliminated since they are not applicable to the revised post.

This strategy involves writing a covered call and adding a protective put (known as a “married put” when the put is part of the trade at entry). The put can be NTM or ITM and will typically have an expiration several months out, perhaps the nearest LEAPS put. The concept is to write calls against the stock with the long put backstopping the trade. The downside risk in the trade is the amount the trade’s net debit exceeds the put strike.

Suppose we buy NSM today (April 5 as I revise this post) at $24.64, write the May 25 Call for 0.90 and buy the JAN-08 25 Put for $3.10; our downside risk is $1.84 (26.84 net trade debit - 25.00 strike) - or 6.8%. The simplest approach is to keep writing NSM until called. And if called, buy it again and keep writing. This is of course an oversimplification, since we can trade the calls, trade the stock, etc. Once we pull in an additional 1.84 in credits from trading or option writing, the trade begins to make money. Any transaction that would yield a profit or gain in a covered call trade adds to the stream of credits generated, and any transactional loss adds a debit.

The protective put construction eliminates risk once enough premium or trading gains are brought in to recoup the put premium. In the foregoing example, there is no downside risk (other than generating trading losses) unless you wind up buying NSM at some point above the 25.00 Put strike - which might leave an exposure gap above the put strike.

The ITM put, a little different animal, eliminates downside risk once enough premium or trading gains are brought in to pay the time value in the put - of which there ideally will be very little. If the stock falls, keep writing it, or buying it again and rewriting it. The goal ultimately is to sell the stock by exercising the long put, which recoups the put cost.

The risk in the ITM put construction, interestingly, is that the stock moves up too much. Assume in the NSM example that we bought the JAN-08 30 Put instead of the 25P for 5.90 and NSM gapped to $35 and stayed there, or kept moving up. We would be called out at the 25 Call strike, and the ITM put that cost 5.90 would be seriously OTM, with a greatly reduced value - probably a 1.00 or less. We might eventually trade our way out of the situation, but this would not be a fun position in which to be.

At the appropriate time, either exercise the put to sell the stock or sell the put itself, depending on where the greatest advantage lies. Obviously, the trader can do a lot to engineer strikes to achieve more or less return, with corresponding risk levels, in any put-protected covered call write.

The new “portfolio margin” rules discussed in other posts will really power this strategy to the moon. On April 2nd the new rules came into effect, which base available margin on the portfolio’s risk. It will be possible to run a covered call trade with protective put, putting up only about 5% of the trade cost. The long-term married NTM put eliminates all but a small portion of the risk and will be ideal for using portfolio margin. The ITM put still will pose a risk as noted above that is substantially higher.

Please don’t get misled into running a trade with inappropriate risk levels using too much PM margin simply because you can. Inexperienced traders focus on how much they can make; experienced traders on how much they can lose.

Before everyone takes me to task on the “nearly riskless” language, I understand that there is no truly riskless trade. Shareholders can be wiped out in a bankruptcy reorganization, for example. I have seen traders turn a problematic but salvageable trade into a disaster by poor trading, and have done that myself. Any put-protected covered call strategy relies for ultimate profitability on generating a stream of credits from option writes or trading gains (or both) that exceed the total debits. Trading losses generated while in the trade will either eat up some of the return or result in a loss. And these trades are not “riskless” to the downside until the cost of the put has been recouped.

I will be writing more on the subject from time to time. You might be interested to know that we have been playing with this strategy for a while now (I had always pooh-poohed it as like watching paint dry) and are working on new lists both for current-month collar trades and covered calls with long-term protected puts. We are experimenting to see what parameters yield the most useful trades. These trades are becoming of greater interest because of my belief that a new bear market could be in the offing. Stay tuned.

I understand that puts have been around for a long time, since about 1977. Buying long-term protective puts, both for covered calls and long stock, has been around about as long. This strategy is nothing new and I certainly can make no claim to having invented it (no one could honestly claim that), although my approach - especially to trade selection and execution - is not the same as anyone else’s.

I have bought long-term puts quite a few times to protect covered calls and have bought long-term calls and written current-month calls against them. I have been burned buying long-term ITM puts after a covered call position fell and I averaged down, because the stock came right back.

Every strategy works if done right. Protective puts are just another tool (whose cost must be recouped), and they are by no means required in order to write covered calls with consistent profitability. But if you like the idea of using protective puts as essentially a stop loss technique - where you know the maximum possible loss going in - some variant of this strategy might just be for you.