CallWriter has always taught that one should never write a deeply out-of-the-money (OTM) call unless there is good reason to do so. After all, the OTM call offers less premium than a strike closer to the money and therefore less downside protection.

Our VMI indicator provides that reason, because it can help us to find stocks that have pulled back and found support on high voume. This very often means that the stock will quickly rise, an ideal rationale for and OTM covered call write! High volume - a volume spike - is important, because like music, it don't mean a thing if it ain't got that swing.

Tips on Using VMI

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At reversal (pivot) points in stock price, we often see a climax in volume over about a week that greatly exceeds the preceding average volume. A volume moving average (VMA) overlaid on the volume histogram shows unusual volume spikes quite clearly, as shown in the following SOHU.com (SOHU) daily chart from 2004. I use the 3-day VMA. As in the Goldilocks story, 3 days seems just right for most stocks; perhaps a 4-day average if you are a tad more conservative.

Remember that the stock market was falling through most of 2004, and there were very few writes available on rising stocks. Note SOHU's four volume peaks on the chart: FEB, late APR, early JUNE and late JULY. Though you cannot see it on this chart, SOHU had tested its 200-day moving average in December, reaching a low of $27.80.

You can see readily that spiking volume results in VMA peaks that tower above the preceding volume levels. While the height and base width of the VMA spikes is significant in and of itself (Peaks 1 and 3 above), the real key is how the VMA spike compares to preceding volume levels. The absolute size of the VMA spike is less important than how it compares to preceding volume history. So, what predictive power did these VMA peaks have?

FEB Spike - Peak 1:
This one signalled a reversal and sell-off. In fact, by the time the volume moving average line showed a peak, the stock was down 25%. Interestingly, the volume climax was preceded by a negative MACD crossover, which usually is a lagging indicator. However, 1) the stock's strong run up after testing the 200-day average and 2) the MACD downturn together did more than hint that the large volume spike signaled big trouble. As you might suspect, and negative MACD crossover followed by a VMA spike is not good news, because the climaxing volume confirms the MACD's unhappy forecast.

The experienced call writer would have avoided this set up like the plague, until a clear picture emerged for stock direction. The VMI signalled this one with 4 green bars on February 2nd and 5 green bars on February 3rd. February 4th was the huge volume day, but the VMI had warned well before that!

BAD for Covered Calls = Stock price up + volume spike + negative MACD crossover

APRIL Spike - Peak 2:
This volume spike was much smaller than the one in February, but still larger than the interim's trifling v0lume peaks and substantially higher than interim average volume. The volume spike led the positive MACD crossover by about two weeks! SOHU was declining from an early April test of its 50-day average (from below), so the volume spike suggsted a new run up was brewing.

Even as late as when the MACD signaled a positive crossover, a May OTM call could have been put on. The MADI signalled with 3, 4 and then 5 green bars and made us aware of a possible bullish setup coming. Yes, the stock reversed again in late May, but in this kind of technical setup, you don't want to stick around forever - get the return and get out!

GOOD for Covered Calls = Stock price down + volume spike + positive MACD crossover

JUNE Spike - Peak 3:
A large one, its height and base exceeded even that of February. Though close in time to the April peak, it overshadows it. Once again, the volume spike led the positive MACD crossover by about two weeks. Note how much ground the stock lost from volume spike to MACD crossover - about $5, or 20%. The VMI signal was huge and warned of a dangerously overbought condition.

JULY Spike - Peak 4:
This spike is rather punk compared to the preceding ones. It coincided with a swing high back up to the trend line. But the gap in late July was a warning, as was the test of the trend line and 50-day average.

Obviously, a reversal to the upside that occurs on a volume climax - represented by volume moving average peaks on the above chart - is well worth catching in a covered call write. We should not select a covered call trade just because of the potential reversal, but it certainly adds a reason to jump on one that otherwise qualifies.

Now you know what we are looking for when using VMA analysis: a spike in volume that could presage a reversal to the upside (or warn us of an impending reversal to the downside). In other word, we are seeking volume momentum. This is what CallWriter's VMI indicator is all about.

These volume spikes are picked up by the VMI indicator. As the SOHU chart above shows, sometimes a volume spike foreshadows an opportunity, and sometimes it is the rattler's rattle. The green UP arrow just means UP volume, not necessarily GOOD (up-day) volume.

An up arrow with 3 to 5 green bars indicates a volume surge that is both strong and recent. Before bothering further with the stock, pull up a daily chart(click the stock symbol on the Real-Time List™). If the stock has been rising and is testing or soon to test the trend line or 50- or 200-day moving average, you'd better avoid this puppy. Certainly, avoid it until the gunfight at OK corral is over and you know if the stock won.

Only 1 or 2 green bars on the arrow indicates either: i) a smaller surge that is not very noteworthy, or ii) a large volume surge a little further back in time that is now tailing off. The prospect of a volume surge that is ebbing is exciting for me, because by the time I see it, a stock may have temporarily found support and be making a new advance. This will not impel me to look further at a stock I don't like at first glance (return is too low or too high, weak industry, weak MADI, etc.), but I eagerly look at the chart to see if the gunfight at OK corral has already taken place and the stock is now "safe" to write.

An VMI of 1 to 3 bars will sometimes indicate that a stock has recently pulled back and made a successful test of a support level. Many times, the 4- and 5-bar VMI values means that the stock is in the middle of the volume spike, in which case it is more politic to follow the stock for a few days to learn its intentions than to jump right in.

However, when the stock is in the process of reversing on high volume, a trade is not indicated, because we want to wait to see if the bulls or bears win. If the stock is experiencing high volume at support, it may reverse to the upside - if you suspect this, keep an eye on the stock and check it a few days later. We do not want to enter a trade on a volume spike. The stock may not reverse but accelerate its downtrend.

Of course, if the stock is experiencing a volume spike at resistance, the same thing applies in reverse. If the bulls gain the upper hand and the stock breaks through resistance, this can be an opportunity in the making.

Down Arrow

The down arrows only tell us that recent volume was lower than normal and suggests that volume has been falling.  It does not indicate negative or "bad" volume.

A 4- or 5-bar down arrow suggests that volume has really sloughed off in the last few days. A rally or sell-off during those days may lack steam due to falling volume.

A down arrow with 1 or 2 bars can mean that volume has been sluggish, but can also signal that the stock recently reversed - and volume is low after the climax.

If the stock has a high MADI value on the CallWriter lists (meaning the stock is above its 20- and 50-day averages) but the VMI value is strongly negative, I will pass on the stock unless it is compelling for other reasons - and in this case, I go straight to the chart and make a decision whether to evaluate it further.

 Flat Arrow

The flat arrow tells us only that recent volume has been comparatively unexceptional. Whether slightly up or down, it is flat-lined. But as with low volume, this can signal that a reversal has just occurred - the "gunfight" is over.

It is an article of faith in technical analysis discussions that flat or falling volume when a stock is rising is a bearish divergence. However, I have noticed that once a stock has sold off and is reversing on volume, they frequently sail up with modest or even low volume. Why? The "gunfight" is over, and even modest bullishness will pull the stock back up, with help from covering shorts.

This happens in the broader market, too. Look at the volume in the Dow Jones Industrial Averages (INDU) after the reversal to the upside in March 2009. Volume fell off, but the market didn't care.

Because of its technical nature, the VMI cannot predict the future with 100% accuracy. This is not an exact science, and the VMI is just another piece of information. And this volume moving average (VMA) trick does not seem to work with every stock.

TIP 1: Use a volume moving average and MACD on your chart. The volume moving average simply means to lay a moving average across the volume histogram (the vertical volume bars under the price chart). I use a 3-day average to show volume spikes. If your charts do not allow this, you can get free charts that do by visiting Stockcharts.com (free registration is required), Yahoo.com or freestockcharts.com, among others.

Look at a year or so of action on a daily chart, and also look at a weekly chart, using MACD and the volume moving average. Look at the volume spikes at pivot points, meaning a point the stock has risen or fallen to and then reversed. We are looking to see if the VMI is an accurate signal for the stock, especially in the last 6 months or so. We are looking for predictability - whether the volume surge at a reversal point reliably signals a reversal. The VMI does not work on all stocks, or on any stocks all the time.

If the volume reversal is a reliable signal, I also look at the MACD with standard settings to see if the MACD has a habit - as in the SOHU chart above - of signalling a new up move with a positive crossover.

As covered call writers, we are looking for charts in which the stock has pulled back and is now reversing upward on volume. When I see a volume reversal to the upside AND the MACD is making a positive crossover, the trade is usually great... assuming we are writing a good covered call stock.

If you keep notes on your trades taken from CallWriter lists (you should), you will note that a lot of good trades were on stocks with a VMI that was a flat arrow or a one-bar red or green arrow. This is because the stock had undergone the volume gunfight - the VMI wasn't telling us that a modest little volume spike had occurred, but that a major spike had occurred and the VMI was only showing the tail end of the spike. A quick look at a daily chart will settle the issue.

The reason is that we do not want to write a stock that is in the middle of reversing to the upside on volume. We want that gunfight at OK corral to be finished, with the bears (at least temporarily) beaten.

TIP 2: The higher the volume spike in relation to prior volume spikes, the more reliable and useful it is. A high spike when there are few or no recent volume spikes, is even better. If the spike is higher than normal but preceded by a higher spike recently, it indicates the stock is losing steam as the "gunfights" are being fought with less gusto - fewer bears. As an example, note in the SOHU chart above how Peak 4 was relatively puny in comparison to Peak 3.

The really high-volume stocks do not provide as reliable a signal, because they are traded by huge institutions and there are too many volume spikes, many of which have nothing to do with a reversal.

If your technical analysis chops are not quite developed, you can get an excellent free education in chart reading from the Chart School at Stockcharts.

The Wrap ...

My process of looking for trades is to not waste more time than necessary, and anything that gives me an edge is welcome. The VMI sometimes provides that edge. The higher-volume the stock, the less useful it can be in practice.

A VMI that is one red bar arrow or a flat arrow, in tandem with a MADI that has a slightly negative 20-Day value and a zero value for the 50-day value can indicate that that the stock has recently tested support successively. If the MADI values are high, on the other hand with the same arrows, I tend not to bother looking further, since this does not lead to good trades.