John Brasher's Covered Call Blog

The Market’s Next Test

John Brasher — Thu, 07 Aug 2008 20:26:14 +0000

A reasonable percentage of my posts are about the market, partly because I enjoy it and partly because that is what seems to be consuming everyone these days. I noted in recent newsletter articles that the stock market agains appears to have found the bottom trendline of the channel it’s been in since October 2007. On a weekly chart, the Dow Jones Industrial Average (INDU) indeed seems to have bounced off the channel bottom. It now must test the 200-week simple moving average (SMA), which is at about 11,712:

Note first of all that the upper channel line is almost the same as the (now declining) 50-week SMA. If the market rises that far, it will be simultaneously testing that average and the upper trendline. The prospect of a breakthrough there is not great, as I have discussed. The gray circle on the upper trendline indicates a possible point of intersection for that test. But will the market even advance that far?

The INDU nudged the 200-week average not so long ago and has pulled back. I nevertheless expect a full-on test of the 200 soon, in large part because so many expect it to occur and because a convincing failure there has not yet occurred. If the INDU breaks above the 200, a further advance to test the 50-week average may reasonably be supposed.

The market may, however, pull back to again test the lower trendline, as it did in March, which is noted on the chart above by the green circle. Another leap at the upper trendline is therefore quite likely.

To date, the INDU’s intraday low of 10,827 this year represents nearly a 24% selloff from the intraday high of 14,198. Put differently, the Dow has in less than a year lost nearly a fourth off its all-time high level in October 2007.

A fair question, one on many minds: if the current market is a correction to a major uptrend, when will this correction be over? No one knows, and the technical factors - while helpful - ain’t the whole story. There’s inflation, the economy, and other factors discussed at length by me and many other commentators. I think more selloff is necessary would be necessary to convince everyone that the correction has bottomed - a clear point of capitulation needs to occur.

But truly resuming a new uptrend will require a healthier economy and stronger corporate earnings. Will they be there? If so, the question of whither the market answers itself.

I am bearish now, as most of you know, but the market will in coming months - say by the end of October - make clear whether it is merely correcting a major uptrend still in place or if more bear is to come. I think a resumption of the bull this year or early next year is quite likely, especially given the election. We’ll soon know.

Quick Historical Note:

1. The correction of 2000-02 retraced approximately 38.2%, then later hit 50%, of the rise from 1990. Both are Fibonacci retracement theory numbers. In fact, the Dow declined to previous market top (support) levels from 1998.

2. The current correction already has hit 38.2% of the rise from the bull market’s 2003 beginnings. In fact, the first week of July 2008 saw a fall to 10,827, which is a 50% retracement. The current correction has already hit 2005 support (the INDU’s 2005 top) and has almost hit the 10,752 top from early 2,000.

3. Also on a positive note, the 200-week SMA has not yet turned downward. That downturn will be negative news. should it occur.

Feel better now? I know one thing: the more bearish more people become, the better I feel.

For call writers, of course, all of this is merely an attempt to answer the question of when is best to write covered calls. Right now is good, since the market has hit a (probably) temporary bottom and is gathering for a spring at the upper trendline.

Important Note: If we get another pullback testing the lower trendline, as in March 2008, don’t panic. It is not unlikely. Today’s pullback may indicate a retest of the lower trendline or may just be noise. And don’t forget: we’re in the doldrums time of year, and a lot of traders are on vacation now or not working their hardest.

Mr. Russell’s Downturn - the Longer View

John Brasher — Tue, 05 Aug 2008 14:20:00 +0000

This post is a little longer than usual, but worth it for me to think things through, and - I hope - worth the read for you. Mark Hulberg, whose newsletter tracks the results of investing newsletters, recently noted that Richard Russell has now turned long-term bearish on the stock market. Russell - no spring chicken - is the editor of Dow Theory Letters, a newsletter distributed since 1958 and is the dean of stock market newsletter publishers. Hulberg interprets Russell’s analysis to be that the market’s long-term trendline has been violated and that the market is headed down until further notice.

While Mr. Russell (who is 84) is a formidable technical analyst, I tend to think this bear market is a correction to the stock market’s long-term uptrend. Let’s take a look at the Dow Jones Industrials (INDU) going back to 1994. We see a long-term uptrend that began in the late 1980s, sharply accelerating from late 1994 to the end of 1999. The bear market of 2000-2002 is clearly delineated and we can see a test of the 100-month moving average at the 2002 correction bottom; then the major uptrend resumes through October 2007.

The current market appears to be another major correction to the long-term uptrend. If so, we can reasonably expect the market to continue its oscillations within channels down to the long-term trendline, which also happens to be the 100-month moving average - right where the red circle is drawn.

Of course, when the market tested that average in 2002, the trend line could not have been drawn where it is now; since it is drawn across bottoms, the bottom must clearly have occurred in order to draw it. However, the test of the 100-month average did occur and the market passed the test.

Will the market find support again at the 100-month level (also roughly the trendline) at about the 10,500 level? The odds are good that it will, because at that point all the players except perhaps the public are ready for a reversal and help make it come about. In this view, we are not in a secular bear market, strictly speaking, but a major correction to the major trend. Ditto for the 2000-2002 bear market.

Points to ponder:

1) The market is testing the 50-month average now. While it could find support there and stage a major recovery, it seems unlikely, given the state of the economy, inflation, etc. As I recently noted in a newsletter issue, the market is at the bottom of a declining channel on a weekly chart and likely will rise to the upper channel line, a normal and expected (by me, at any rate) oscillation. Then it will almost certainly resume plumbing for the major trendline down about 10,500.

2) The 100-month average is going negative (curling over and pointing down). If the 50-month follows suit, expect a test of the 200-month.

3) If the market fails at the 100-month average, the next major INDU support level is at about 7,750, the 2002 correction bottom. That would be about a 45% selloff from the highest close at 14,164. By this I don’t mean a 45% retracement; it would mean a loss of nearly half the Dow’s value. That seems a little extreme. Possible, but not so likely.

The Retracement Perspective:

Retracement theory posits that a market, after a rise with no major correction, will correct - retrace - much of the move up. Many, including myself, rely on the Fibonacci sequence. In the early 2000s bear market, the market retraced almost a perfect 50%, as shown in the next chart.

A 50% retracement in the current bear movement (10,889) would take us almost to the 100-month average and the trendline. But heck, we almost hit that on July 15th. A trip down to the 7,750-level on the INDU would be a 100% retracement (they happen). The chart below demonstrates the Fibonacci levels for both the 1999 and 2007 peaks (the green line is the 100-month average again):

Note how much sharper the selloff has been this time than in the 2000-02 correction. The contrast is a bit unsettling. I think this market is ginning up a greater than 50% correction, since we almost touched that in July. At the very least, it will test the 100-month average. While anything could happen, there is no reason to think the correction is done. There simply is nothing to break the downtrend’s progress.

I’m in Palm Coast, Florida, for the week, though we have broadband and can get phone messages.

Financials: The New “F” Word

John Brasher — Tue, 29 Jul 2008 15:26:10 +0000

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.

Expect a Down Market Today; Financials & Housing

John Brasher — Tue, 22 Jul 2008 13:08:53 +0000

Stock futures are pointing strongly down before the open. The S&P 500, Nasdaq 100 and Dow Jones Industrials all fell this morning, which usually augurs a stock market selloff - just as stock futures strongly up usually mean an up day. This does not mean that the market’s apparent bounce off the bottom of its channel (discussed in my most recent newsletter issue) is invalidated, because an index - like a stock - often needs multiple tests of a support level before it can take off.

Thus if the market does sell off back to the 11,000 level, it is not cause for panic. To the contrary, for the market to find support there again would presage a nice rise back toward the upper channel line.

FINANCIALS:
These are poison for any long stock position until further notice. This goes for all financials - brokers, banks, mortgage-related and insurance. If you assume the other shoe has dropped for Citi and Bank of America, you are gambling. Save it for Vegas. It is not just the subprime, either. Even with my SuperPut strategy (buy a long-term put to protect a covered call position), why buy a stock that poses considerable danger?

HOUSING:
Don’t go there, no matter how tempted by the “bargains” available. The recent “surge” in housing starts was phony, a result of NYC changing its definition of what is considered a housing start. Eliminate that, and housing starts fell.

Expiration and the Assignment Trap

John Brasher — Fri, 18 Jul 2008 15:27:45 +0000

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.

“Russell Volatility” Ahead?

John Brasher — Mon, 02 Jun 2008 03:13:09 +0000

Russell Investments (www.russell.com), a subsidiary of Northwestern Mutual Life Insurance Co., provides some influential equity indices - the best known being the Russell 2000 Index - and Russell claims that over $4.4 trillion in investment assets is tied to them. There appear to be 120 index funds linked to Russell, of which 20 are Russell 2000 index funds.

On June 27 Russell will reconstitute its indices for 2008, meaning that some stocks currently included will be ditched, and new ones added. Analysts expect over 300 new companies will be added to the small-cap index, including 40 or more companies dropping down from the 1000 to the 2000. The Russell 2000 is mostly populated by small- and mid-caps.

The managers of all those Russell-linked funds will have to adjust their holdings to follow the revamped indices. An AP article reports that hedge funds and others will try to take advantage of the changes, and that analysts are already war-gaming who’s in and who’s out.

Companies added or deleted, or downgraded, will experience some volatility as funds rebalance to adjust holdings. The volatility could be severe for deleted small-cap companies with significant institutional holdings when the big holders rotate out of them. And some companies will benefit.

Financials currently make up 20% of the Russell 2000, and some of them will be ditched, another reason to be very careful of them for July expiration. For reasons explained in my new book and in newsletter articles, I don’t write covered calls on, and don’t espouse the writing of, mid-caps very often and small-caps, never.

But if you do write or trade these, be aware that you could be bushwhacked on such stocks, even before June 27 - if the market decides a company is “marked.”

Your Stock, or the Broker’s?

John Brasher — Mon, 17 Mar 2008 18:08:47 +0000

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.

Another Goofy Market Day

John Brasher — Tue, 22 Jan 2008 19:04:02 +0000

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.

Protect Yourself

John Brasher — Mon, 21 Jan 2008 23:39:59 +0000

Today (Martin Luther King Day) the US stock markets were closed, but the US futures market was open, as were foreign markets. The picture is fairly grim. Foreign markets are down 4% (Canada) to 7% (Paris). Stocks in Europe are now down more than 20% below 2007 highs, which meets technical definitions of a move into a bear market there. The pan-European Dow Jones Stoxx 600 index slid 5.4% on losses from Societe Generale, Allianz and other banks and insurance funds.

The global sell-off has been blamed on lukewarm reaction to President Bush’s stimulus plan announced last week, but the world’s markets have been cocked and primed for this as the credit crunch worsens and the extent of the subprime problem becomes clearer. Negative comments about subprime from a French banking official sent the Paris market down the most of all. They are now trying to erase his remarks, but the damage was done. This was Europe’s worst sell-off day since 9-11.

US futures were sharply down today, as well. Futures were down on the DJIA (520 points), S&P 500 (60 points) and Nasdaq (76 points). Whenever futures are down before the stock market opens, it usually heralds a down market day. Unless futures spike up tomorrow morning (and perhaps even if they do), there is a real likelihood of a further fall in the stock market.

For those who read the tea leaves, this is not good news. Major publications are using the “R” word pretty freely now, along with terms like “global free fall” and “global train wreck.” I don’t know if it’s as bad as all that, but it ain’t good. Things are going to get worse, much worse.

Let’s look at some charts:

The DOW closed at 12,099 on Friday, which is almost 15% below its 2007 high of 14,198 and well below August’s correction low of 12,517. We have a long way to go to reach the 20% mark off the 2007 high (11,358), which would be a technical signal we are in a bear market. The bear is, I have noted on prior occasions, snuffling his way our way. It’s only a matter of time. Is the time now? Maybe, but my money is on a snapback in the market and continuing the rolling pattern it has been in - if we don’t break sharply lower. In the chart below, note how the DOW has broken below its recent trading range, with two closes below the bottom trendline:

The sell off in recent weeks has occurred on increasing volume. The DOW is now testing the low of the Feb-March correction from 2007. Just doodling on the chart, below, I am wondering if we have not possibly seen a head-and-shoulders top to the market?

It looks kind of like a H&S, and the neckline falls rather classically, does it not? If the top was a head-and-shoulders formation, then the market has broken decisively below the neckline. Needless to say, a break (several closes) below the Feb-March correction low will be trouble. I think the old bull still has some legs left. At some point, traders and investors will decide that the market has sold off enough (for now) and buying will come roaring back in. The problem is, the big institutional players actually read and digest the financial news and its economic implications and are bearish. But the problem with going to cash is that so many places we would put our cash also are beset with subprime and similar problems in their asset mix. Hmmm, want to put your money in a bank? Better pick the right one…

What to do?

First, be watching the futures before the stock market open tomorrow, which MarketWatch.com usually covers. Although I rarely trade in the first 30 minutes of the day, be thinking about buying puts to cover long stock. I would consider buying ATM or near-the-money FEB puts on unprotected positions. If the market does not sell off or the sell-off is short lived, close the puts. A short-term bullish sign would be for the DOW to break higher back into (close in) the range it has been making. Even at 9-11, the market didn’t keep plunging, and it won’t this time, either. I will only buy puts tomorrow for the opportunity to profit on them if the market seems to be selling off again, because I expect the market to snap back.

Second, your future covered call writes should be SuperPut-protected. Those who wrote at higher price levels using the SuperPut strategy are not concerned with the market sell-off. Bluntly, it ain’t their problem. This is the way you should be trading. Limit your losses to a few percent of the trade debit, and soon make the trade completely riskless. This is the way to write covered calls, and you can do it all through the worst bear market. In fact, the dropping stock becomes your friend.

I’ll be giving out more information soon about my SuperPut strategy and our new SuperPut lists, so keep watching. A bear market is to be feared only by those who aren’t protecting their stocks properly.

Trade Adjustments Today - AMZN

John Brasher — Fri, 04 Jan 2008 17:18:10 +0000

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):

COVERED CALL - John Brasher
Date	Sym.	Ident.	Order	Price	Debit
1/03/08	AMZN	Amazon	BOT	97.00	97.00
1/03/08	ZQNAT	JAN 95C	STO	-4.80	92.20
Stock falls to 90.67
1/03/08	ZQNAT	JAN 95C	BTC	1.97	94.17
1/03/08	ZQNBR	FEB 90P	STO	8.15	86.02

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.