Some believe that you should buy more of a stock when it drops in a covered call trade. Due no doubt to recent market volatility, I have been getting this question a lot.

I disagree emphatically. Only in the rarest case should you average down, and then only when major trade entry criteria are met.

The practice of "averaging down" means to buy more of a stock as it is dropping, the rationale being that doing so lowers your average cost in the shares. Unfortunately, your "average" cost still will be higher – perhaps substantially higher – than the market value of the stock. Some covered call writers believe that you should average down when the stock drops on you in a covered call trade. Others, such as me, believe you should almost never average down. Who is right? Read on and decide for yourself.

I remember a stock broker years ago urging me to average down, keep buying a stock as it dropped. He emphasized what a great position I would be in when it recovered. I thought about it and asked him this question: "Even assuming you're right, what conceivable advantage is there in buying more shares at this point? Shouldn't I wait until the stock has found clear support and is moving back up before doubling down in the stock?"

He was disappointed, since he made a big part of his living in those days on commissions, and it was a technique he used to increase his income. But I was more concerned about my income.

First: Don't Catch a Falling Knife

I don't doubt that averaging down works on occasion; probably trading based on your astrological chart will work on occasion (I'm not knocking astrology, so no emails, please). But even if you believe the stock will recover, there is NO REASON to buy a stock that is still dropping. No matter what your trading strategy, it makes no sense to BUY the stock as it drops. Short it, yes, but not buy it. You sell weakness; you don't buy it.

Every trading strategy has a timing element. For every trade, no matter the type of strategy used, there is a good time to enter the trade, the best time and the wrong time. Why on earth would you or I buy a falling knife until we were fairly sure of a recovery? The answer is that we should never do that.

I'm not alone in this sentiment. Pick up any trading book, read any article on trading, and they will invariably tell you not to add to a losing trade – and averaging down adds to a losing trade. It is almost universally considered an amateur mistake. Even if, on further analysis, the falling stock is one you consider a great investment, the smart trader doesn't buy it while it drops, but buys it at the most advantageous price and time - as discussed in detail below.

Second: Figure Out Why the Stock is Dropping

A stock may drop on a negative earnings surprise or even pull back on a positive earnings announcement, if there are no more buyers. The entire industry or sector may be selling off (or perhaps your stock is a smaller company that closely follows a larger company that is very similar, that sells off), taking your stock with it. Or negative news may have been announced by the company. There are many possible reasons, but they resolve into two categories: 1) a negative event concerning the company itself, or 2) weakness in the market or industry.

If the stock falls with the market or industry, you have a better chance of riding it out. The chance is good that at some point, which can take several months, the market will recover to test the level from which it fell. A good example is the market selloff that began in early May 2006. It caused a lot of concern, but the market has pretty much recovered as I write this. Weaker stocks and most tech stocks haven't shared in the recovery, but good stocks (the kind you should be writing covered calls on) have come back.

The worst possible reason for the stock to go down is the announcement of negative news. The stock is then on its own, and you cannot expect much help from an improvement in the market or industry. The same thing happens when a stock closely follows a larger company that sells off. If you don't roll the calls down or close the trade, you can be stuck in the stock. It happens to everybody, including me. Why the stock is dropping (or has dropped) will be a major factor in your decision how to react to the selloff and, of course, whether you should remotely entertain thoughts of averaging down.

Now we're getting to the core question…

Should You Ever Average Down?

Maybe, rarely; but carefully and only at the right time and for the right reasons. First and foremost, realize that when a stock drops unexpectedly, you called it wrong. That seems harsh, but it isn't. We all call trades wrong. Perhaps you were caught by unexpected news. Or perhaps you gambled that a certain event would resolve in a positive manner for the company, and it didn't. Perhaps you were lazy and missed the impending news event altogether. Maybe the industry sold off on a bad earnings announcement from the industry's big dog. Whatever, you called it wrong.

When the stock sells off, it is a new trade. You have to re-evaluate it. Should you wait for a recovery or sell the stock? Analysis will tell you what to do, but it is a new ball game at this point. Averaging down is a possible action, one of many, but you never buy more of a stock just because it is getting cheaper.

It really resolves to this question: if you didn't already own the stock, would you buy it now? If the answer is no, why on earth would you buy more simply because you are already stuck in the trade? You would not.

If the answer is YES, then - and only then - should you consider averaging down. Then it becomes a question of WHEN to buy more - at what price and how much.

Rule for Averaging Down - If You Must

What I don't want you to take away from this article is the notion that I champion the practice of averaging down. I do not. But there may be limited circumstances when it makes sense. Here are those circumstances, in my view:

1) The trade was good to start with. You analyzed the company carefully before entering the trade and selected it based on fundamental and technical criteria. Consistently successful covered call writing is mostly about stock selection - you should be looking for the best companies in the best industries in the best sectors, basically.

Conversely, if you picked the stock without careful analysis off a covered call list, or from a scan, you haven't met rule #1, and averaging down ain't looking good. If it wasn't a great stock based on careful consideration before entry, it certainly hasn't improved by dropping! It is not likely to become an excellent covered call candidate - much less an investment candidate to load up on - at this point.

2) The stock has hit bottom and is recovering. As noted above, you should not consider buying more of a fallen angel until you are sure it has bottomed (found major support) and is on the mend. The stock should make a determined test of a support level on significant volume and move up. Whatever technical indicators you use, you want to see a string of closes above the support level and money coming into the stock. This means not catching the actual bottom, but for a trader it is far more valuable to know that the stock has bottomed than to get the lowest possible price. Until it has bottomed and the technicals meet entry signals for a long trade, hands off. Even if you believe in the stock (#3 below) and think you should load up on it, you still have to figure out when to buy it. If this technical approach sounds too seat-of-the-pants... it beats blindly buying a falling stock.

Determining whether the stock finally has found support is pretty much straight technical analysis. Company news releases may provide some light, but the key still is how the market will react to the news. And don't forget: every other trader out there is seeing the same chart you're seeing.

3) The company is still good. The test for this is stated above: upon careful analysis, you would be willing to buy this stock NOW as an investment. If the company was hit by really negative news (poor earnings guidance for coming year, its arthritis drug is killing people, etc.), the prognosis for the short and medium term is not good. Are the company's prospects essentially unchanged, or are they worse? If worse, why on earth would you buy more of it? The ideal candidate is a great stock that has suffered a market-overreaction to news and will bounce back.

If the stock fell with the overall market, I would be more inclined to buy more of it than if the stock itself had taken a hit. If the stock's industry has taken a hit, I would be less likely to average down, since industries have cycles, and it makes no sense to buy more of a stock when the industry is in the ditch. A stock investor might disagree, but we are covered call writers, right?

Am I saying that you should instead dump a covered call stock that is falling? Of course not. I always look to see what is happening to the stock if it is not falling with the overall market. I look at the industry and look closely at the stock itself. I want information.

In my considered view, any stock that surprises you - to the good or bad - essentially becomes a new (or at least different) trade, requiring fresh analysis before new action is taken. No matter what the circumstance, whether the stock is falling and I am deciding how to react, or the stock is advancing and I must decide whether to roll up, I re-analyze the stock. It only takes a couple of minutes, usually. I look at a couple of charts, check for news, maybe Google for recent articles to see what is being said, etc.

Those who say you should, as a typical practice, average down on any stock that collapses are peddling dangerous medicine.

Rewriting Issues on Fallen Angels

Some will urge you to average down on the theory that you can keep writing calls on the fallen stock, generating income, known as rewriting. Keep in mind that when a stock's price has really fallen, it is tough to write calls on it. Once the stock has settled into a new trading range and is no longer volatile, it can be reliably written. But - options will no longer carry fat premium as a general rule.

And remember, even after averaging down your cost basis will still be higher than current market. If you write ATM calls on a stock that is down, you risk being called out at the lower price for a loss. On the other hand, if you write OTM, in order to write a strike far enough OTM to avoid taking a loss if assigned means getting so little premium that there is little point even writing it. Writing ITM is out of the question; you will be assigned for a loss unless the stock drops even more!

Some will tell you the answer is simply to write OTM calls months out, perhaps even the next LEAPS call, in order to get enough premium. This tactic can work, but when a stock has fallen and settled into a new trading range, even an OTM call many months out might offer only a miniscule premium for the risk. If a $25 stock has fallen to $15, even writing the 25C out a year in time might bring in only a few bucks. If you write only slightly OTM, say the 17.5C or 20C in this example, the stock could resume a new advance, forcing you at some point to buy back the call to avoid being assigned at a loss.

I'll talk more about rewriting fallen stocks in a subsequent issue, but it is not always as simple as "keep writing them" when they're down. In my view, selling longer-term OTM calls on a fallen stock is not some clever strategy; it is simply a repair strategy. Your position has been impaired and if you can get some income out of the fallen stock, by all means do it.

An important point needs to be made here. Sure, the stock still is an asset and you still can write calls on it, which will generate some income. But unlike the case with a new buy-write trade, if called out at the low strike price you will take a loss. This factor significantly circumscribes your ability to rewrite the stock and forces you into mostly OTM writes, which offer the least premium.

The income stream from this kind of repair writing is better than a sharp stick in the eye, but it is not a place you would ever want to be and it is not a justification to buy more of the fallen stock.

Final Thoughts

My point is this: even if analysis indicates your fallen stock is now a really good stock to own, it does not mean that it is now a good stock to write covered calls on - because you are under water. So when you average down, you are really investing for the medium or possibly long term. If you think the fallen stock is now a great investment, reach your own conclusions. Even if you're right that the stock will come back eventually, do you really want to tie up more cash in a fallen angel?

But averaging down is not and never will be a covered call strategy. It is an investment strategy. Think long and hard before tying more of your income-generating capital up by purchasing more of a stock that so limits your ability to make money from writing it.

LEAPS is a registered trademark of the Chicago Board Options Exchange.

"Naked Writing" in Covered Calls

Question: 
I've been looking into naked call writing, which I know can be dangerous. I heard you say on a TeleLab once that the ability to write naked can be a great tool for a covered call writer. Why would anybody ever write naked, considering the possibly catastrophic losses that can be incurred?

Answer:
Writing a naked call means to sell call options without owning the underlying stock. The writer of a naked call faces the risk that the stock price will increase, forcing the writer to buy the stock at a higher price than the calls' strike price in order to deliver it when assigned (or buy back the calls at a higher price to close). Writing naked poses a theoretically unlimited risk, since the stock - at least in theory - could go to infinity. While this is unlikely to happen, the point is that the naked writer has real exposure. More to the point, your brokerage firm is exposed to loss on your trades, since they must make delivery if you cannot.

Traders write naked calls well OTM on stocks that are in trouble and usually with a strong technical advantage - for example, a stock showing real weakness with a huge resistance level between the stock price and the call strike written. These writers plan on buying the stock to cover if the stock price hits the call strike. They could get caught with their shorts down, so to speak, but so could we all. That's naked writing in a nutshell. Now, let's look at how a covered writer could make use of naked calls.

Being qualified to write naked calls in your account can be a huge advantage for the covered call writer. After all, the stock is the "bitey" end of the trade. When bad news comes out after the bell, it is not possible to buy back the short calls in a covered call position, because US option markets are closed. Most covered call writers in that situation can only wring their hands as they watch the stock fall, unable to close the position. Being unable to write naked, if they tried to sell the stock in the after-market, their brokerage firm either would not allow the sale, or would immediately buy the stock back in. One whose account is approved for naked call writing, though, could sell the stock in the after-market and then either close the calls when most advantageous or let them expire worthless.

This covered call technique isn't typical naked writing, but really is the same thing. The risk in the trade for the a covered writer who sells the underlying stock and leaves the calls short is no different than if the write had started out as a naked one. Certainly, your broker will consider it naked and treat it as such. A reversal in the stock that gains back its selloff and makes new highs exposes the trader (and thus the firm) to a whipsaw loss. Naked writing in general is not for inexperienced traders and certainly not for the faint of heart nor the light of pocketbook. But it can come in very handy for after-the-bell selloffs.