December 1, 2004

Analyzing Covered Call Trades
Evaluation Process for an Actual Trade - MRVL
by John Brasher, CallWriter Publisher

While we provide many covered call tutorials - including trade analysis - on our members' website, we know that the best teaching always is by example. So today we are going to share with you our trade analysis process on a trade we actually picked for the November 2004 expiration month, which made over 3% in three days for traders during expiration week. This is how we do it.

On Wednesday, November 17th, we picked the following trade and featured it for CallWriter members on our members website in the Closer Look Report:

How we Analyzed It

The Process.  Our process for analyzing covered call trades is described in detail on the CallWriter members site. Basically, we look closely at the trades presented on our Real Time Lists™ and some baseline data appearing on the lists. Then, as we find trades of potential interest, we do a more detailed evaluation using the CallWriter Research Page that pops up from the lists. Let's get to it.

The Market.  Before looking at the lists, I check out the market. I might already have looked at it, but however you do it, be aware of what the market is doing. Your trading should be made in the light of market direction. For example, there's little point in picking low-return ITM trades when the market is strong. As the chart below shows, the market (illustrated by the INDU) had broken out of a prolonged downtrend on November 4th - meaning it broke decisively above the upper trend line and above the important 50-day and 100-day moving averages. I like the market to be showing strength and energy. It was just a reaction to the election, I know, since no other news out there could have powered it. But the fish are either biting or they're not, and at this point they were. The chart below illustrates the market's action at that point.

The Return.   First, I liked the return. This MRVL trade offered a 3.68% for a 3-day trade, a huge return, an average of 1.23% per day. This return for 3 days equates to over 30% a month. [3.68/3 = 1.23 x 30 = 36.9% for a month] High returns like this for a few days during expiration week can frequently be found. It is always the case, however, that any trade offering a high return bears close examination, and this is just as true expiration week as any other time.

Fundamentals.  MRVL is a profitable company that designs, develops and markets integrated circuits for communication-related markets. I am very reluctant to write unprofitable companies, since in a market or sector reversal the money-losers get hit the hardest and stay down the longest. There are exceptions, but the ones bleeding red ink are not my first choice.

The P/E (price-earnings) Ratio is a bit high at 85 in light of the industry average of 32, but not so high as to ring alarm bells. While the P/E is almost three times the industry average, the price-to-book value was actually slightly lower than the industry average, indicating a solid value. (Book value is a company's net worth after liabilities)

Average volume is strong, over 4 million shares daily - I prefer that our covered writes have average volume of at least 1 mil. shares, and 2 mil. is even better. The P/E Ratio and average daily volume numbers appear right on the lists, and other ratios and detailed financial information, including a company profile, can be pulled up instantly using the Snapshot link on the CallWriter Research Page.

Impending News.  Whenever a stock hits our Real Time Lists™ there is a reason for it. Stocks offer high covered call returns when implied volatility is high, and implied volatility is high when the market expects the stock may move. Implied volatility does not necessarily predict future volatility, but the possibility is there, and the market is willing to pay more for calls and puts when it thinks the stock may move. The question then becomes: why does the market think this stock might move? The invariable answer is that news is expected. The reason for the high covered call return is that MRVL was due to report earnings Thursday the 18th after the bell, which we learned quickly from the Earnings link on the CallWriter Research Page. Normally, an impending earnings report is cause for concern, since a stock can sell off on a bad earnings report - or even on a good one.

Bad signs, among others, would include a stock that has run up heavily on earnings anticipation (they tend to sell off) and a stock that typically takes a battering on earnings announcements. MRVL, however, has a tendency to do well on earnings reports, and had run up only slightly in anticipation of the report. I confirmed this with a quick glance at a chart pulled up from the Chart link on the CallWriter Research Page. Looking back over the last few earnings announcements, MRVL does not betray a tendency to sell off on earnings news. Some do, some usually don't; some are uneven and you never know. While no stock comes with a guarantee it won't sell off, I felt comfortable that MRVL would handle its earnings release without serious damage.

Technical Analysis.  One of the first things I note on each trade is the moving averages. Our Real Time Lists™ present the 14- and 50-day moving averages as positive or negative numbers in the form of the MADI (the moving average directional indicator, a CallWriter proprietary indicator). While this is not an absolute necessity, I liked the fact that MRVL was above both the 14- and 50-day moving averages, a classical sign of a good covered call write.  (Note: a stock below these moving averages can be written, but such writes may require a different approach, which we describe on our website and in other evaluation articles like this one.)

In mid-August MRVL tested the May low and went into a nice uptrend, and by early October had gone into a trading range. While there never is any assurance in trading, the October trading range was in all likelihood a consolidation pattern on the way to higher highs. (Indeed, this is precisely what happened: MRVL moved higher on the earnings announcement.)

A positive MACD crossover had just occurred, just as MRVL found support at the $27 level. This support level was massive, having been tested twice already in October, and had earlier been a strong resistance level tested several times in June and September, as indicated on the accompanying chart. (A resistance level becomes support once the stock breaks the resistance level; and vice versa.) Notice on the chart below that MRVL not only bounced off the support level, it also bounced off the 50-day moving average - a nice confirmation that support had been found. Even though it is not a primary trading indicator for me, I also liked the fact that the RSI (relative strength index oscillator) was at 60, a good mid-point number, neither overbought nor oversold.

The MRVL chart presents something else interesting, that you don't see every day. Notice how this stock has not, since mid-August, traded below the bottom of any large white candle, including the most recent one at November 12th. The bottom line is that the stock is showing strength in this stock, and a rock-solid support level at or slightly above the $27 mark. For these reasons, and because MRVL is a solid company in a good uptrend, I felt good about featuring this play for our members.

Support and Resistance.  MRVL was right at the $30 resistance level when I picked it. Sometimes this is cause for concern, because a stock's usual routine will be to hit the resistance level and pull back. As a very general thing, stocks at resistance are better handled with an ITM strike in order to get more downside protection against a pullback. And MRVL had already tested that resistance level three times recently. Still, on the basis of fundamental and technical analysis noted above, I felt good about this trade. As noted above, there was major support at about $27, and if it broke support, the next support levels were about $25 and $22.50. Yet, that $27 support level was rock solid.

Stop-Loss and Roll Points.  When entering a covered call trade, it is smart to figure out your stop loss (the point at which you will exit the trade if the calls are not rolled down) and the roll point, which is the point at which you would likely roll the calls down by repurchasing them and selling lower-strike calls. When calls are rolled down, you really have a new trade and would then define a new stop loss. Note that the trade's breakeven point (stock price paid - premium received) is 28.89. If I close the trade below that point, I take a loss.

Stop Loss: While we normally define our stop-loss in terms of a support level and our breakeven point in the trade, I decided I would not trust MRVL below 28.10 and to set the stop loss there if the trade was not rolled down. The reason is that MRVL's opening price on the large Nov. 12th white candle was 28.55 (give it .45 of wiggle room), and breaking below that candle would have been a very poor technical sign for me. An alternative would be to set the stop slightly below the $27 support level, but I didn't like that approach in the MRVL trade, because breakeven was 28.89, and waiting until below $27 to stop out would yield a bigger loss than would be acceptable in this trade. Wouldn't it be nice in this trade to have the breakeven point below the support level?

Roll Point:  Support or no support, therefore, I decided that I would be watching the trade carefully if MRVL broke $29 and ready to roll the call down to the 27.50 or 25 strike call. That is, if the stock broke the 28.85 level a roll down would be in order, since there might not be a practical roll down if I waited for the stock to go much lower. The reason is that calls are rolled down when the stock is showing technical weakness, at a point when it seems to be tipping over, but when a good premium still can be gotten for the lower-strike call. If you wait until the stock has dropped too far, you can't enough for selling the lower-strike call to make the roll worthwhile. So even waiting until 28.85 might have been too late. There is no formula or magic point for a roll down, and you can never fix it in advance; the roll point is just a signpost in the trade. When to roll? Do it when the stock shows real weakness, when the lower-strike premium is right for you.

Final Analysis

The MRVL trade worked well. As you can see from the analysis that went into it, this trade was not luck; it was not randomly picked, nor chosen just for the return. Had the stock failed our analysis at any point, we would have passed on it. Period. While our analytical process is no guarantee of success in any trade, it works for the vast majority of them. As we present different trade setups, you will learn different approaches to them.

In an era when money managers crow about 10% annual returns, we just made 3.68% in three days. Run the trade on Wednesday, close it Friday, and you are ready to put your money back to work the next Monday. Not bad.

Sound complicated?   Truthfully, it is not. It is amazing how fast people from all walks of life - even those with no prior trading experience - can learn how to write covered calls and master our trading method.

Want to Know a Secret?  In case you are worrying that the above analysis took forever... It took me over 1 hour to write the above article, but the trade analysis took about 6 minutes.

Good luck and good trading!