June 11, 2003

How to Set Up Charts for Covered Call Writing
by John Brasher, CallWriter Publisher
 

No two people do their charting the same or use exactly the same "tool kit" for trading. The charting set-up described below is very close to the one that we use at CallWriter, although with a number of variations, since we change sensitivity settings depending on the behavior of the market currently and over the past few months. Keep in mind that these settings and indicators are all relative to the information you want.

Charting a course...

For example, a covered call writer might use a daily chart, but a day trader concentrating in S&P futures might trade off a 1-minute chart, because for him a 2-hour trade is a long one. Studies are analytic tools that are overlaid onto the price chart, so that you can see the study results in regard to price and volume. Studies also are called "analytics". There are hundreds of studies, but among the most useful are the moving averages (MA) and MACD, discussed in more detail below.

This article is not intended to teach technical analysis in depth, only to discuss basic chart and indicator settings, using price, volume, moving averages and trend lines. One thing that every neophyte technical analyst has to learn is to use different pieces of market information to try and confirm an entry or exit signal. If all indicators are good and confirming each other, the trade is very promising, and vice-versa. If the indicators are mixed, you have to reconsider a trade or look for different confirmation that makes sense.

For call writers and option investors who have not developed individual preferences as to chart style and settings and indicators to use, the following settings and indicators will help them get off to a good start:

Price Chart
We use a candlestick chart, since in our opinion this will show you formations like trading ranges, flags, daily gaps, etc., better than any other chart style. Each candle on the chart is known as a bar. For writing covered calls and for straight option trades, we normally use a daily chart, which means that every candle (bar) represents one trading day. If less than 10 days remain until expiration, however, we also look at a 60 min. chart (every bar is one hour) to make sure that it is confirming the stock's direction we are seeing on the daily chart. Always chart a stock before executing any investment strategy. Also chart the market, too - S&P, or Nasdaq Composite if the stock is Nasdaq traded.

Use a bar chart if you prefer it, but they are not as good at showing activity at a glance as are candlestick charts - not as intuitive. A simple closing-price line does not contain much information and is next to useless.

Moving Averages
The MA is an average of the stock's prices over a defined period of time and it is expressed as a line that is overlaid on top of the price chart to show how the current price is interacting with the MA - that is, above it, below it or testing it. The most commonly used are the 14, 50, 100 and 200 MAs. There is a simple moving average (SMA), which simply is the average of closing prices and the current price over the MA period shown. An exponential moving average (EMA) is a little more complex and weights recent prices more heavily than older prices and thus smooths the line. The EMA is better for almost every purpose. Note the MAs overlaid on the following 2003 daily chart (the 14, 50, 100 and 200) in candlestick format and how the stock is interacting with each MA:

In June 2003, the DOW is above all four MA lines, indicating an up-trending market that has been moving up for weeks. In a down-trending market, the DOW could easily be below all four. But notice how the DOW first broke above the 200 MA on March 21st but couldn't hold above it, peeked above the 200 MA several times and then finally crossed the 200 on April 21st. This definitive cross-over foreshadowed the DOW's trend breakout on April 28th (see next chart). Because the DOW had been below the 200 MA since June 3, crossing above the 200 was an important sign. Notice on the above chart how the movement against the 200 MA is much more significant than interactions with the other MAs. The next most significant interaction, as far as predictive power, is the 100 MA.

We like to set up our charts so that the 200 MA is overlaid on the price chart as the prime MA, along with a shorter-period MA, such as the 50. Always use two MAs with different periods, which we explain below. However, if the market (or stock) has been in a prolonged up or down trend, the 200 is not helpful, because every stock will be above or below the 200 MA. In that case, we use a shorter period; ideally, the 100 MA. If that also is not helpful, then we like the 14 and 50 MA both are overlaid on the price chart, since these two lines represent 3 and 10 weeks' trading averages on a daily chart, respectively, and using both short MAs lets you see at a glance how the market (or stock) is doing compared to each MA.

How to USE Moving Averages
For writing covered calls and doing other neutral to bullish option strategies, you want the stock price to be above the prime MA being used (200 for us, or shorter period if necessary) and either continuing to climb above the MA or running parallel to it. If the stock has broken below the prime MA or is still above it but declining to the MA, this is a bearish sign. usually is the 200.

Your should always use TWO different MAs on your price chart: good combinations are 200/50, 100/50, 100/20 or 50/14. You don't want to use two periods that are too close in time length. The reason for this is that the interaction of the two MAs is as significant as where price is in relation to the prime MA. The key is what the shorter-period MA is doing in relation to the longer-period MA. A cross of the shorter period above the longer period is a bullish sign, and a cross of the shorter below the longer is bearish. Note on the above chart how this works. I put an "X" where every MA crossover occurred. Notice how the price moved up after certain crossovers, down after others. Notice also how (generally) the bigger the difference in time values, the more significant the crossover?

Next critical point: notice how it sometimes makes a difference how the crossover occurs? When the two MAs cross almost horizontally (one essentially parallel to the other), the following price action is usually not that dramatic, although there certainly are exceptions. But when the two lines cross perpendicularly or have a really wide gap, the price action over the next few bars tends to be very significant. When price is paralleling a prime MA, or both MAs on the chart, this is a sign of stability at the time. This having been said, every cross has significance.

For initiating covered call and other neutral to bullish plays, we like to see the current price above both Moving Averages. Next best is if the shorter period is crossing above or already has crossed above the longer period line and price hasn't had time to move above both MAs. [The opposite movement is a sell or short signal.] What if the stock is already below both Moving Averages? If it bounces off the 200-day MA a (instead of crossing below it), this is a show of strength by the stock, and the stock is a possible covered call or straight option play. The more decisive the bounce, the greater the show of strength. You also want to see the 200 MA climbing toward the price line.

Trend Lines
The trend lines indicate the range of trading prices to be expected based upon the trend to date. A trend line is a straight line that can be drawn under three or more pullbacks from rallies or over three or more bouncebacks from declines. We have found that the trend lines frequently are more accurate at forecasting support and resistance than horizontal support and resistance lines, which is why traders and investors use trend lines. Don't trade just upon trend lines, however; they are just another confirming tool. Trend lines are not studies but are drawn on the price chart itself. Bollinger Bands and other price envelope bands also are a form of trend analysis, which many investors like. We don't find them particularly useful, but they make work for you. Try a lot of different methods of looking at price trends to see what works for you. Look at the following daily bar chart on the Dow Jones Industrial Averages, and note how it stayed faithfully within the blue trend lines from December 2, 2002 through April 28, 2003, when it broke out of that trend and began a new trend:

Try to find a charting program, or a trading platform with charting, that will allow you to draw trend lines on the price chart. With practice, you'll be able to see most trends in your mind's eye.

Volume histogram
We like to put the volume histogram at the bottom of the price chart. It shows the daily volume in vertical bars (red=down day; black=up day). This is essential, since many price movements are meaningless without knowing the associated volume. For example, unusually high volume over several trading days is a key to identifying a real top or bottom; false tops and bottoms are suggested by a relative lack of large and sustained volume. If a stock is hitting resistance or support, volume is a key indicator in trying to divine the likelihood of a breakout or pullback. Volume is not the most important study on the price chart - usually -and many times it will be ignored. However, it is a good confirmation of many event, such as reversal points and breakouts and can be critical in separating the real thing from a false signal.

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In a subsequent article, we will discuss other powerful indicators that we have found useful: the MACD, the RSI and others. Our sensitivity settings sometimes vary extremely from what many traders use and from the standard "canned" sensitivity settings that many studies use, so stay tuned.

Good luck and good trading!