April 23, 2003

Naked Calls, Long Puts and Shorts, Oh My!
by John Brasher, Publisher

With apologies to Dorothy, we get this question a lot: The MONEY newsLETTER is always talking about naked calls, bearfoot strategies, puts and shorts, but aren't you primarily a covered call writing service?      Actually, no! CallWriter's MONEY newsLETTER is about making money. Finding the right stock and employing the proper strategy is how we do that. You can find good stock candidates many ways. It just so happens, we look to CallWriter's Real Time Lists™ to find our picks. Our Real Time Lists™ are lists of the highest-returning covered call plays, which means that they are showing us the stocks with the highest implied volatility at that time.

Traders make money on volatility

So, our Real Time Lists™ are good for many different strategies, such as short sales, naked calls, spreads and buying and selling puts. Keep in mind that a stock's price can do only 1 of 3 things before expiration: go up, go down or hold price (not move significantly). We note below how each strategy wins based on the three possible stock price movements. For example, a 2/3 means that the strategy wins on 2 of the 3 possible price movements.

So here are our thoughts on how to find the right candidates for short sales, naked calls, long puts and short puts using CallWriter's Real Time Lists™, based on long experience with them:

Short Sales
To make you money, the short stock must decline. We like the Under $15 and the $15 and Over lists, because these are our most volatile lists, and the stocks appearing on them generally are the most likely to move. Stocks on these two lists without earnings and showing low call volume and low open interest are promising ones to start with. From a technical standpoint, we look for stocks on these lists that appear to be trending down or pulling back from resistance. Some traders look for channeling stocks that appear to have crested in their channel and started the next decline phase. You can usually find good short candidates on the other lists, too, but these lists consistently have the most of them. 1/3

Naked Calls
The naked call wins if the stock declines or holds price. We believe that the only safe way to write naked calls is to write out-of-the-money (OTM) calls in order to leave room for the stock to advance slightly. Our Deep Out of the Money lists show you calls that are at least 10% out of the money. We believe that good naked call candidates are those that appear, based on technical analysis, to be trending down or likely to hold price before expiration. The above analysis of short sale candidates applies equally to naked call candidates. Naked calls should not be written when the market is trending up, since a rising tide tends to lift all boats. 2/3

Long Puts
The stock must decline for the long put to win. Since this is a debit strategy (meaning a net debit to run the trade), you lose money over time unless you can consistently pick stocks that decline before put expiration. Buying puts involves essentially the same analysis as you would apply above under Short Sales in choosing short sale candidates, since the stock has to decline enough before expiration to make the put valuable. Long puts are ideal on stocks in a clear down trend and, generally, in falling markets. For this reason, we would consult the Under $15 and the $15 and Over lists for long put candidates. 1/3

Short (naked) Puts
A naked put is a synthetic covered call, and it wins and loses the same as a covered call. That is, if the stock holds price or goes up, the naked put seller wins by keeping the put premium and not having the stock put to him. For this reason, it is paramount to pick a stock that appears unlikely to go down. This means you want quality stocks with a lower likelihood of moving significantly before expiration, not highly volatile stocks. For this reason, the naked put writer wants a stable, boring stock, not the fattest premium, since the fattest premiums attach to the stocks with the most implied volatility. The ideal naked put candidate will be in a clear up trend or break out or will have made a convincing bounce off support. Naked puts should not be written in a declining market, since virtually all stocks will fall. For short puts as for covered calls, our S&P 100 lists are the most reliable in this bull market, since these are, as a group, the most stable stocks. Second choice would be our NASDAQ 100 lists. 2/3

Thoughts on Analysis
Having made these observations, each potential trade will require analysis. Traders and investors cannot safely run a trade - no matter what strategy is being employed - merely because a stock appears on one of our lists or based merely upon its position on one of our lists. Traders should use whatever analytical process works for them in determining trades.

We also urge members to consider the wider implications for each stock than just its own news and chart. For example, last week the stock market faltered and AMD should have gone down with the market midweek (and usually would have). However, chip maker Intel announced positive earnings, which buoyed AMD. A short position in AMD or long AMD put, which we briefly considered, would have been a bad play. We decided to pass on the AMD short precisely because Intel's earnings report was pending. Good thing, since it still is up a week later. We strongly believe that a trader's analysis must take into account at a minimum:

(1) the stock itself,
(2) the stock's sector and bellwether stocks in the sector, and
(3) the trend of the overall market.

Our Real Time Lists™ simply show us where the volatility is. Without implied volatility, there is not a fat, juicy premium - which is what covered call writers are after, after all. But those of you who like making short sales, writing naked calls or puts, or buying puts also need volatility for consistent profits, and nothing shows you where the volatility is like our Real Time Lists™.

Good luck and good trading!