Our Real Time Lists™ present the highest-returning covered call trades. As is the case with all such lists, every covered call play is on there because call premiums are high. When option premiums become high, they are said to imply potential volatility in the price of the underlying stock. Thus we say that implied volatility is high when premium is high. A spike in premium does not mean that the stock is about to become volatile (they usually don't), it only forecasts that it might. Wall Street makes money when prices move, so it's not surprising that market makers charge more for options when they think the stock might move. Traders will pay more where potential volatility exists.

If the stock is already moving, on the other hand, then options on it will be expensive, because there is no expectation of a move - the move is happening. Buying calls or puts on a moving stock is a no-brainer, except that options are expensive. As a rule, Wall Street does not give money away - the exception that comes readiest to mind being covered call writers, who profit from the posturing, hedging and positioning of large market players. For those of you new to covered call writing, this is explained in a nice little parable at Feeding Amongst the Elephants. When options are more desirable, they are more expensive; basic free market forces at work.

Call option prices therefore spike up for one ot two reasons: 1) either news (a "volatility event") is pending that Wall Street thinks may move the stock price, or 2) the stock is already moving based on news about the company or some other impetus. Sometimes, however, premium is expensive due to both reasons. That is, a stock can already be moving based on impending news, such as an upcoming earnings report.

The Importance of News

But while Wall Street is giving a nice income to us covered writers, the flip side is that we have to be careful when premium is high due to an impending event It is important for us to ascertain what the news is and when it is expected. Some types of news, such as earnings announcements due, are easy to find and can be gotten from our lists with a mouse click. The nature of the news must be assessed in relation to the company and its prospects. Really big news can not only rock the stock but send the entire industry into rotation (a sell off) if it affects one of the leading companies in the industry. On the other hand, the news may be more of the garden variety that has little effect on the stock.

News items can include such things as impending earnings, an FDA ruling or clinical study results on a drug or medical device (Merck), outcome of major litigation (RIMM) and many other events. Not all news events are equal, obviously. And not all news on the way will be necessarily significant. Our concern as covered call writers boils down to just a few things:

Nature of the Event
What is the nature of the news; how important is the news in and of itself, irrespective of the size and wealth of the company? There is a continuum of materiality, from horrible to ho-hum. Some news is positively incendiary; think Enron or Adelphia, or Delphi's announcement of a Chapter 11 filing. News can be major but less draconian. For example, if a judge is about to rule on whether the company's core technology infringes another's patent, or the FDA withdraws Vioxx from the market - that's pretty material, no matter how large or august the company. Most of the time, the news is more mundane. The real news might even be about another company - see the Bellwether discussion below.

Significance to Company
Once you know what the news is, how significant is it to THIS company? Companies don't face life-and-death news or even significant news every day. So the more common question we have to answer is how significant is the volatility event likely to be in light of the company's size and prospects. For example, an FDA thumbs up or thumbs down on a drug application might not be a big deal for a major drug company like Merck, unless it involved a flagship drug like Vioxx responsible for a lot of corporate earnings. Yet the same FDA ruling could be life-or-death news to a small biopharma with only a few drugs in the pipeline. For an example, see the NABI Pharmaceuticals example below.

The announcement that the upcoming year will see a drop in revenue or profitability can knock a solid, profitable company for a loop, But the same news about a company that has never been profitable, or a large company that is struggling to regain profitability (think Xerox not so long ago), might not affect the stock that much, because the street's expectations are already low. You can only judge most news events in the context of the company's current posture - size, profitability, prospects, market share, technological leadership and the like. There is no one-size-fits-all template against which we can measure a news event.

News Timing
Naturally, it matters when the news is due. It usually is safe to write a stock if you can be out before the news is released. See the Timing caption below.

Major News vs. Technicals: Guess Which Wins?

No matter how strong the stock's fundamentals or how juicy the technical picture, if major news is coming, the stock can still move strongly either way. If the stock runs up, groovy. But what if the news is bad? You guessed it... the stock will almost certainly sell off. And so much of the bad news comes after the bell, when you cannot buy back the call. You have to decide how significant the news would be for the company, assuming worst (or best case). Sometimes the news is not bad; it's a question of whether the company gets something good.

Here's a great example: NABI Pharmaceuticals (NABI), which was on our OCT and NOV 2005 lists with a huge return. The problem is that NABI had no revenues and only one drug in the development pipeline, which was expecting the results of a Phase III clinical study - truly life or death news for this little company. And NABI was scheduled to announce the results on the Tuesday after OCT option expiration; in fact, before the bell on Tuesday. This really meant that one could write the OCT calls on NABI for a lovely return, but if not called out before expiration, the trade HAD to be closed on the Monday following OCT expiration to get out of town before the bad news.

Looking only at the technical picture, NABI was lovely. The technical Opinions page on our lists (a compendium of technical indicators) had NABI in a solid buy. The fundamentals were not pretty, granted; it quite obviously was a small company with no revenues. But the strong tecnicals didn't matter one whit when NABI announced that its drug didn't work (in delightful drug-ese jargon, the study failed to make its endpoint). NABI collapsed from $13 to $3.

Suppose a company is up for a huge contract? If it doesn't win the contract, the company is no worse off than before, right? But if the stock has run up on anticipation of the news, the stock is likely to sell off if the contract is not received. In fact, the stock can sell off even if the contract is awarded (buy the rumor, sell the news), if everyone who wants to be long the stock is already in it by the date of the announcement.

Timing: When the Rain Comes

As NABI illustrates, timing is everything, in trading as in so many other things. Holding a stock through a major news event is just not smart trading. You'll get away with it sometimes, but the riskis too great for the covered writer, who is looking for a small, defined return. Note that on earnings plays, stocks that are going to sell off increasingly tend to do so a few days before earnings are announced. Thus one planning to write a stock awaiting earnings and be out before it reports had better figure on being out a few days before.

But please note my real point about timing. NABI was not a bad covered call play. It was only bad for the NOV expiration cycle. It was great for the OCT cycle. In fact, since everyone was watching for the clincal trial results, the stock was on autopilot in the OCT cycle, effectively immunized from the disaster to come. Using proper timing on NABI worked like a charm for traders out of the stock before the news hit.

Using timing in this manner will transform your covered call writing. Ignoring the timing angle, or worse, ignoring the news altogether will result in unnecessary losses.

Don't Forget the Bellwethers

The large companies that dominate an industry group are known as "bellwether" stocks. Many times the stock of a smaller player in the same industry will closely track a bellwether stock. Nothing is more frustrating than to write a stock that passes every analytical smell test and watch it tank on absolutely no news. When a good company does that, you will almost always find that it is merely following the fortunes of a bellwether stock that is tanking. As noted above, a serious hit to a bellwether stock can cause the entire industry group to sell off. For that matter, premium on a smaller industry player can spike due solely to impending news on a bellwether, simply because the market knows it will move with the larger company.

When writing a bellwether stock, we don't have this concern - which is why a lot of covered writers like to stick with industry leaders.

Is it required to research the bellwether companies also? No, but your trading will be more successful if you do when writing small and mid-size companies, because industry and sector rotation is a fact of modern trading. I've been caught by this, more than once, which is how I learned it in the first place. For more information on this topic, see my previous article Finding the Bellwether Stocks.

Related is the vendor issue, in which a company's principal customer is a particular industry group or company. Good examples might be specialty chip manufacturers or auto parts makers. Any downturn in the fortunes of the client company or industry will hurt the vendor. This simply underlines the importance of knowing what a company does before you write calls on it.

Quick Wrap-Up

I don't want anyone to walk away from this article thinking that it is unduly difficult to find the news. It isn't. It just takes some digging, and it gets easier the more of it you do. It's not like a backwoods water witch with a hickory wishbone stick trying to divine where to put a water well. It's worth the effort.

But the need to find the news - why the premium is high - is important, and trust me... it separates the successful covered writers from the others. For us, news is THE most important piece of the fundamental puzzle.

Question:  I'm not clear on the concept of tactical unwinds of covered call trades. What exactly do you mean by that?

Answer:  The term tactical unwind is a term I use, not really an industry term. It means to unwind (close) a covered call trade early, instead of letting it go to expiration, when you can do so at an acceptable profit. For example, suppose we wrote a 30-day covered call with an expectation of a 5% return if the stock is not called away. Then, a few days into the trade, suppose the anticipated news on the stock (the reason the play hit our Real Time Lists™ in the first place) is released, the market doesn't react to it and the stock remains relatively unchanged on the news. However, the call premiums will be greatly affected even though the stock is not, because with news no longer pending, there is no longer an expectation of an imminent stock price movement. Suddenly, the market is no longer willing to overpay for options on this stock, so option premiums on the stock collapse back to "normal" pre-news levels, including the call we sold.

We can now close the trade for a nice return, perhaps 3% or 3.5% - less than the 5% originally anticipated (but sometimes better than anticipated), but still a nice return for a few days!. And we can turn the money right back into another trade if we want, with most of a month still remaining until expiration. This collapse in premium occurs somewhat frequently.

A good example: Hewlett Packard (HPQ) was on our S&P 100 list for both FEB and MAR with good returns in the 30 Call. Then HPQ announced earnings on Wednesday, February 15th, a very positive announcement. On Thursday the 16th as I write this, HPQ is up several dollars and the premium in the 30 Calls has collapsed; the return offered now for the MAR calls is only pennies. One who was in an HPQ MAR covered call trade could close the position profitably today. [We would not consider closing the FEB position, since there is only 1 day left before expiration; no point incurring extra commissions.]

Any early close of a covered write could be considered a tactical unwind, including a close to escape a deteriorating trade. But I really reserve the term for the scenario in which the trader uses the technique to maximize premium income, intending to turn the funds back into another trade. An acceptable profit is the minimum return you are willing to accept for closing the trade.