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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.
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.
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.
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.
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.
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.
This
issue's Question and Answer:
Tactical Unwinds of Covered Call Trades
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.
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