July 26, 2004

There are no bad markets...
Only Bad Trading Strategies
by John Brasher, CallWriter Publisher

All traders understand that there really is no such thing as a bad stock market. The reason is that no matter what the market is doing, there will be winners and losers. Obviously, everyone makes money in a strong bull market, and that is the most wonderful time to be a call writer or even call buyer. By the same token, If the market is dropping like a rock, it is wonderful for shorts and put buyers. The market has been falling since late June and is approaching a major support level. So is there a strategy for covered call writing at this point?

This newsletter does not as a usual thing feature a lot of charts and market prognostication, but today we're going to evaluate some market charts. We will discuss where it seems to be going (down) and talk about some strategies CallWriter members use to turn what is normally thought of as a bad thing - a down market - into trading profits. This newsletter is longer than usual, but bear with us, because it's worth the read.

Trading is the art of taking what the market will give you, because no one beats the market. As a famous trader pointed out, when you take money out of the market, it is because you understood the same thing the market did. Bull markets really require no discussion here, partly because pretty much everyone knows what to do then, but more to the point, we're not in one. Let's take a look at a daily chart of the the Dow Jones Industrial Average (INDU), which despite its drawbacks is unquestionably the leading U.S. market indicator:

It could better be named the Down Jones Average at this point. The INDU rebounded from a 7416 low in March 2003 and was in a strong uptrend through February 2004. Closing Friday, July 23rd at 9962, the INDU is not far off its 9852 support level, and could easily reach it in a single trading session. Note how price touched the uptrend line four times (at A, B, C and D) before decisively breaking the trend line at E. As far as I am concerned - and technicians sometimes disagree on these things - the trend really ended on April 6th, because that is the point at which the INDU stopped making higher highs. That is, for the uptrend to continue the price would have had to bounce off the pullback at D and make a new high, which did not happen.

Note how the INDU made its last high on February 11, 2004. Let's focus now on price action since that high:

While some would describe the action since then as a rolling market, I think this is unduly optimistic. To my old eyes the market is in a clear down trend. After all, pronouncing a down trend is not a matter of divination, it is simply a matter of identifying lower highs and lower lows, which is exactly what the market has been doing since the February high. The INDU tried to break out of the down trend beginning on June 8th and had eight closes above the upper trend line, but lacked the energy to continue. As you chartists know, a failed breakout is one of the most reliable of all technical signals. The question is whether the market will find support at the 9852 level or make new lows. This time of the year usually is the doldrums for the market, and this year seems no exception. So the prognosis for a market advance at this time is not good.

I won't describe the current market as a doom and gloom situation, because it offers trading opportunities. It always does. So how can this market best be traded? Without getting into exotic trading strategies, here are five that CallWriter members use profitably in such a market.

1. Write Deep-in-the-Money (DITM) Calls.

Write covered calls that are deeply in the money, meaning that the call's strike price is less than the stock's price at trade entry. For safety's sake, the call strikes should be at least 10% in the money and we prefer to see 20+%. Generally, the more the better. High returns on call strikes this deeply in the money can be found on large S&P or Nasdaq 100 stocks. Even a stock that drops 30% in a year will seldom lose all that value in a couple of weeks. The profit potential of DITM stocks is precisely why CallWriter offers lists of DITM covered call trades.

Most downtrends are fairly linear. But here's a word of caution: be careful with this strategy in a dropping market. Use it primarily on very large and stable high-volume stocks that are in a linear downtrend, meaning that they are dropping at fairly predictable rates. If the downward trendline is really steep, or the stock is typically volatile and moves around a lot, pass on it.

These trades frequently - and surprisingly - offer a wonderful chance to unwind them at a strong profit, ten days or less after the trade is entered. Trades meeting our entry criteria (acceptable return, at least 10% ITM) will have a fairly high amount of time value. The reason the early close so frequently works is that volatility collapses and causes the time value component of the premium to mostly evaporate. You can then buy back the calls for much less than the price paid.

2. Write Naked Calls.

Simply write calls without buying the underlying stock. The premium is 100% pure profit, since there is no offsetting debit. As always, naked calls should be written out of the money, since no stock is ever to be fully trusted. In other words, if the stock is $20, it is vastly safer to write the 22.50 or 25 Call, not the 20 Call, because you must leave a buffer - room for the stock to oscillate. If the stock is $19, it might be safe to write the 20 Call. The exact size of the safety buffer will vary by trader, but we rarely use a buffer less than 5%. If you write at the money (or even worse, in the money) the trade requires that the stock actually move below your strike and that it do so by expiration. Never forget that there is such a thing as early exercise, and while the odds against it are long, it does happen. Naked writing is a tough strategy to implement, since so few traders have the account approval level or the account size to do it. But there is no better strategy than writing OTM naked calls in a dropping market, since you keep all the premium from selling the calls. CallWriter offers lists of deep out-of-the-money covered call trades, which also is a fabulous place to find naked call trades.

3. Bear Call Spreads.

A spread is simply another way to cover a call. That is, instead of buying the underlying stock to cover the call, you buy another call on the same stock with a different strike price but the same expiration. A bear call spread, wihch is a credit spread, is a tactic in which you sell the lower strike and buy the higher strike to cover. (Ex: Sell the 20 Call, Buy the 22.50 or 25 Call) Obviously, these do not fully cover the call, since there is a spread between the strikes. If you sell the 20 Call and buy the 22.50 call, there is a $2.50 spread. Here is how it works. Using our example, sell the 22.50 Call for $2.25 and buy the 25 Call for $1.10, which creates a net credit to you of $1.15 on trade entry. If the trade works, you simply let the calls expire and keep the $1.15 net credit. If you called the stock wrong and it shows strength, close the spread. The worst case is a loss, which would be the amount of the net spread ($2.50 total spread less $1.15 credit received = a net spread of $1.45).

Bear call spreads offer some wonderful features. First, when written out of the money, they win if the underlying stock drops or just holds its price. Therefore picks doggy stocks! It doesn't even have to go down, just not go up. Small stocks with low volume and low open interest in the calls tend to be ideal. Second, they generate a net credit when the trade is run, putting money in your pocket. To close the trade, simply let it go to expiration, or buy back the short call and sell the long call.

Bear call spreads are best written out of the money. Thus if the underlying stock is at $20, the trader should write the 22.50/25 or the 25/30 spread. As is the case with naked calls, you must leave room for the stock to oscillate, so the lower strike sold should be a few percentage points higher than the stock price when written. You can find bear call trades using CallWriter by visiting our Research Page, clicking on the Options link and changing the covered call chains to call spread chains. Simply determine the bid price for Symbol 1 (the short strike) and the asked price for Symbol 2 (the long strike), which gives you the net credit and spread.

4. Bear Put Spreads.

Unlike the bear call spread, the bear put spread is a debit spread, which means that there is a net debit paid upon trade entry. To create the trade, you buy the higher-strike put and sell the lower-strike put, both with the same expiration. The net spread (total spread - debit paid = net spread) is the maximum profit that this trade can generate. Assume the stock is $21 and the trader buys the 20 Put and sells the 15 Put: the spread on the trade is $5.00. If the trader pays a net debit of $2.00 and the stock closes below the 15 Put, the trader stands to make the maximum profit of $3.00 (5.00 - 2.00 debit = 3.00 profit). To close the trade, simply let it go to expiration, or buy back the short put and sell the long put.

The underlying stock should be exhibiting real weakness, since the bear put spread wins only if the stock moves far enough and does so by expiration. Thus picking a stock that simply is not going up is not enough. It has to go down. The ideal trade candidate is weak both technically and fundamentally and is under pressure. If you're really certain of a significant price movement, the long put usually is the better trade,

Obviously, the lower the trade debit in relation to the amount of the total spread, the greater the potential profitability. And just as obviously, the farther out of the money the spread is, the lower the trade debit will be, but the further the stock will have to move to make the trade win. Should you create the bear put spread at, in or out of the money? It really doesn't matter, since this spread depends on the stock's movement to make it win. Thus it is a matter of how much of a debit you want to pay on trade creation. It is seldom possible to create a profitable debit spread that is in the money, meaning that both put strikes are lower than the stock's price, because the market sets these prices and isn't giving money away. Even when a small profit is there, trading costs usually eat it up. Debit sprads usually are created out of the money or with one strike in the money and one strike out.

For example, assume that the underlying stock is $69 at the time of trade entry. Let's look at mixed-strike, in-the-money and out-of-the -money put debit spreads for August 2004:

The chart above uses actual closing prices from Friday, July 23, 2004 for Lehman Brothers Holdings (LEH). The in-the-money 75/70 spread looks like a sure winner, doesn't it, since the short 70 strike is above the current price? However, for maximum profit, the stock would have to close below $70 at August 20th expiration; it's no sure bet (although looking at the LEH chart, perhaps not a bad one). On the other hand, the 80/75 in-the-money spread is a dead loser that cannot win under any circumstance, since the spread is $5.00 and it costs $5.10 to run. The out-of-the-money spread would be the most profitable by far, but maximum profitability requires the stock to move almost $10. A trader expecting a move on that scale might be better off just buying puts.

As with long puts, the trader is not seeking high premiums nor implied volatility but is looking for declining stocks. A good way to find bear call trades using CallWriter is to visit our Research Page, clicking on the Options link and changing the covered call chains to put spread chains. Simply determine the asked price for Symbol 1 (the long strike) and the bid price for Symbol 2 (the short strike), which gives you the net debit and spread.

5. Long puts.

Simply buying puts on downtrending stocks is an easy winner in a down market. The best bet is to choose stocks that are weaker than the overall market. You are not looking for implied volatility necessarily, but a clear downtrend, so you should not be interested in paying the highest price for the puts. Remember that the market shoots the wounded first, so pick the weak and hurting stocks. Look for stocks that are good long put candidates and buy the put. Be sure to buy enough time, keeping in mind that the market has a tendency to stabilize prices through the current expiration. Put chains can be found many places, including through CallWriter's Reseach Page utility.

Tactical Note

All the strategies above sometimes will offer the opportunity to close the trade early at a nice profit - sometimes at a higher profit than you originally planned. Stock and option prices never remain static but change in response to many different market inputs. The most significant by far is the collapse in volatility. Never assume that the trade must go to expiration, unless an adverse move forces you to unwind it. Many times a collapse in volatility will cause a price shift that creates profitability from an early unwinding of the trade. This is not always possible, but underlines why traders have to keep an eye on prices.

Timing Concerns:

Hard-core bearish plays are a poor idea just as the market is testing support. We would be very careful about buying puts or writing naked calls in the next few days until the market has tested the 9852 support level and either broken through it or found support. The reason is that if the market finds support and advances again, both trades are almost certain to lose, since a rising tide lifts almost all boats.

Finding Trades:

Finding option quotes for trades is not difficult, as noted above under each trade strategy. For those of you who are not CallWriter members, option chains can be found at many free financial sites. One of our favorite free sites is Yahoo!, which offers an Option Dragon, an option screener and many other options services.

What not to do:

This is not a time to sell naked puts, obviously, since a dropping market will almost guarantee a loss on every position. But it also is not a time to write out-of-the-money calls, nor in our opinion even at-the-money (ATM) calls, except on the strongest of stocks and with very strong premium.

So despite the current downtrend, there is no reason for any trader to be a wallflower. The ability to find and put on trades that take advantage of market movements is a keystone of successful trading.

Good luck and good trading!