June 24, 2003

Covered Call Trading Tips
Vol. 1: Finding Calls to Write
by John Brasher, CallWriter Publisher
 

Stock option trading (meaning buying calls and puts) is about speculating on stock price movements. Covered call trading, though, is about income generation: making investors a 3%-5% monthly return (higher with margin). Even novice investors can quickly learn to get good, consistent returns. Covered call trading is not a speculative "swing for the fences" strategy. It's about making a great income, and it’s a stock option trading strategy that works. By properly employing a covered call trading strategy, you can make monthly returns that are obtainable and sustainable.

It's not rocket science...

Covered calls are in fact pretty simple. You buy a stock and sell call options on those shares. The income from selling the call options (the premium) goes into your pocket. The call is "covered" because you own the stock. You do this every month and generate a regular return. This is stock option trading at its easiest and most profitable. You may be thinking yes, but which stocks?

Easy - good ones whose call options pay a fat return. There are many ways to find these stocks, but we believe CallWriter offers the simplest, fastest and best solution. Our Real Time Lists™ of the highest-returning covered calls and Position Management Calculator™ (that shows you where the most money is after you're in a covered call trade) are proprietary and unique, so you can only get them at CallWriter. We developed the lists and calculator for our own trading use and only later turned them into website tools, so they're designed to make money for traders (like you), and we know they work.

Trading education is a big part of our philosophy. We want to address a few important topics. So we like occasionally to talk about our trading philosophy and habits - how to use CallWriter to consistently make those kinds of returns.

So here are some tips on using our Real Time Lists™
to find covered call candidates and make money with them.

Aren't many of the stocks on your lists volatile?
Yes, and thank heavens! Remember that the highest-yielding covered calls are those with the highest implied volatility (IV), not always the most volatile. When IV is high, there is a reason. IV does not necessarily mean the stock will be volatile, just that the market thinks or expects it will be. But IV is on the other hand what creates the profit opportunity. If a volatility event (lawsuit resolution, FDA approval, earnings announcement, etc.) is pending or anticipated during the option cycle, we avoid writing a covered call or any covered position, since we can't be sure of the result.

What you see on our Real Time Lists™ will reflect what's happening in the overall market and sometimes a particular sector. When tech gets hot, for example, there will suddenly be a lot of tech stocks on the list. Pharma and bio stocks are frequently on our Under $15 and Over $15 lists, since many of them are waiting for the results of an FDA hearing, but they aren't so prevalent on the S&P100 and Nasdaq 100 lists.

How do the stocks on the Real Time Lists™ fare?
They usually fare thee well. The Real Time Lists™ also show you counter-trending stocks that are stronger (or weaker) than the overall market or sector. Remember that the market was much higher in March 2002 (over 10,000) than it is now, and that after the October 2002 rally it went into another prolonged slide on 12/2/02 that only ended at the start of the current rally on March 1. I took a look at our lists recently. Five of the ten stocks on our June S&P100 list performed substantially better than the overall market and trended counter to the market when it tanked in December 2002:

Of the 10 stocks on the list, only two (MEDI and NXTL) were at 52-wk. highs. The stocks listed above, except MEDI, largely ignored the December 2002 pullback and actually ran counter to the market trend. The other five stocks either trended with the market or did worse than the market. These would have been extremely strong stocks to write covered calls on. We also took a list at our June Nasdaq 100 list, which wasn't as strong:

Except for YHOO, every stock on this list that counter-trended the market also was an S&P100 stock, which amplifies our insistence that the S&P100 list is the safest one to write. There were also some strong, counter-trending stocks on the June Over $15 lists, such as APPX, SEPR, ANPI, MOGN, NSM, OVTI, CELG and NFLX. Some of these are pharma or bio stocks and, before a covered call write could be put on any of these stocks, news would have to checked on it to determine if FDA approvals are pending during the option cycle. Remember, they're on the lists for a reason. But each has stood the test of time since October 2002 or further back and defied the overall market. These results are are not un-typical for our lists.

Click on the stock symbol on our lists. This will pull up a detailed quote page with a java chart. A look at the 3-month and 1-year chart will show you how the stock has been moving and how it is doing in comparison to the S&P and Nasdaq Composite. By the way, before looking at any stock, look at the S&P and Nasdaq Composite charts so you know what the market is doing. We like to keep an S&P100 chart open while looking at stocks so we can compare them.

How useful is the MADI (Our Special Moving Average Indicator) ?
This indicator can be very useful. The MADI (moving average directional indicator) appears on our Real Time Lists™ and tells you how the current stock price relates to the moving average of the stock's price over the last 14 days. This indicator is a proprietary one developed by LogiCapital!

If the MADI has a low value of 0 to +5, then the stock is currently stable and hasn't moved much in the last 14 days, which often is a good sign for call writers. A MADI of +5 indicates that the current price is 10% higher than the 14-day moving average. A MADI greater than -10 or +10 indicates strong current movement and therefore, volatility. Avoid the stocks with a negative MADI and look for stocks with a MADI of 0 to +5. If the MADI is higher than +5, look closely at the news. You don't choose a candidate based on the MADI, but it is a good starting point. Next, look at the stock's chart and then look for earnings and other news.

Should we avoid stocks without earnings?
Generally, yes, but you have to use your head on this criterion. The percentage of stocks with earnings changes from time to time as the economy swings, and companies in a sector tend to do well or poorly as a group. The market expects good earnings in a good economy or if the sector is doing well, and cuts companies slack when the economy or sector is struggling. Also, companies are opportunistic and will sneak through the alley with bad earnings news when they can.

Example, in the last quarter of 2001 the market was paralyzed by 9-11 and the Enron debacle, so many companies with losses to recognize (pension fund liabilities, etc.) took the losses in the 4th quarter while no one was watching. By the next year, the losses were old news.

So while we generally avoid stocks without earnings, we make exceptions for strong, household-name stocks like Lucent or Xerox that have a deep and liquid enough market not to tank on slightly bad news, or for which the market already expects a loss and the loss is already figured into the stock price. If losses are negligible or the result of extraordinary events (like one-time writeoffs) or if earnings are expected in the next quarter, we can ignore losses if the company is strong. The worst offenders are the ones that have never made money, like a batter who has never hit.

If earnings news is due before expiration, be cautious .
Be carefully about writing covered calls on stocks that have earnings news due before option expiration. The reason is that adverse news can do serious damage to the stock, even a major stock like Microsoft. The news could be good, too, but how can you know? Get familiar with the term earnings surprise. The market penalizes companies for missing its earnings estimate, oftentimes severely. A company sometimes is penalized even when it makes its own number but falls short of the "concensus" number (the market's independent estimated earnings number).

A good site for earnings news is www.earnings.com. Another good site that we like is www.earningswhispers.com. (Companies facing FDA approval tend to be especially good candidates for straddles or strangles.)

How do I safely start writing covered calls?
It's easier than you think. The great beauty of writing covered calls is that it is a 2 out of 3 strategy. Stocks can advance, decline or hold price, and covered calls make you money when the stock holds its price or advances. Buying a stock and hoping for a price advance is a 1 0f 3 strategy. The key to generating a consistent income from writing covered calls is to choose stocks with strong premium, while avoiding flaky stocks that, despite their high premiums, are more likely than not to hurt you. For stable stocks that are likely to hold price or move up and are less likely to hurt you, start with our S&P100 list and look for stocks with a low MADI of 0 to +5.

Next, look at the stock's chart to see if the stock is trending up, consolidating or trending down and see how it has done in the past few months compared to the S&P100 or the DJIA. If the stock is trending down or about to hit resistance, avoid it. If the market is trending down, be careful about writing any stock unless it is clearly counter-trending and stronger than the market. Then look for news to make sure the stock doesn't have an earnings announcement, FDA approval, etc., expected during the option cycle. The stock is on our lists for a reason. Get your sea legs first, and start with the most stable stocks on the planet.

I'm an experienced covered call writer and want hotter returns!
Fine, but remember that the greater the reward, the greater the risk. You get a higher return on OTM (out-of-the-money) calls when the stock is called out, so consider writing stocks on our Deep Out of the Money lists. If the stock is moving strongly and potentially devasting news is not expected before option expiration, consider writing an OTM call, because the stock will be more likely than most stocks on our lists to get called out, and the return is much higher on an OTM call if you get called out.

Our Deep Out of the Money lists give you calls that are a minimum of 10% out of the money. Start your analysis with stocks with a high MADI, +10 or more. They're moving. Chart them and look for news to divine why they're moving. Calls written in the money and at the money only pay you the flat return - - if exercised, there is no additional gravy. Also, look at our Nasdaq 100, Under $15 and Over $15 lists, since these tend to be hotter and have a higher yield than S&P stocks. Again, start your analysis with stocks having a MADI of +10 or more, then look for news.

These thoughts are highly simplified, but future articles will discuss in more detail how to choose stocks from our Real Time Lists™, how to analyze them, how to check for dangerous news, and how to make consistent monthly returns.

Good luck and good trading!