July 19, 2006

Handling the Dropping Market
by John Brasher, CallWriter Publisher

A market correction is an inevitable part of writing covered calls. In fact, questions on what to do in a dropping market make up a good part of my mailbag these days. Anyone who boasts of never being caught in a market decline has not written many of them. Yes, it happens to all of us. Let's look at the realistic alternatives when the market corrects.

Though many tend to forget it after a prolonged bull market, all markets correct sooner or later. Corrections can be temporary or herald a new bear market, but they have to be dealt with. And despite the popularity of sentiment indicators, selloffs can occur due to unforeseeable events, like Israel’s attack on Lebanon in July 2006. This article will explore some of the tools the covered writer uses to cope with market selloffs and some of the timing aspects of trade management. First Things First Before getting into the dropping-market toolbag, you must understand the vital importance of trade selection in covered writing. Nowhere is this more important than when the market corrects, because there is a flight to quality and out of tech and junk stocks. Being in weak or over-priced stocks will really hurt you when the market declines. Tech stocks have done poorly this year, anyway; they were only going to get worse during a correction. The CallWriter philosophy is to stick with strong, industry-leading stocks. Ideally we would always write the best stocks in the best industries in the best sectors. Strength and quality are your best protection. There isn't space in this newsletter issue to go into depth on the subject, but the further your stock selection deviates from this ideal, the worse you will do over time. Having said that, trade management matters, also. If you bought a $20 stock and wrote the 20 Call on it for a $1.00 premium (resulting in a cost basis of $19), waiting until the stock is $15 before taking any action is somewhat like closing the barn door after the horses are already out of sight. Dexterous trade management requires that you act while the acting matters most. #1: Rolling Down In my experience, covered call writers don’t roll down nearly as much as they should. Inexperienced covered writers in particular have a tendency to freeze when the market drops. Rolling down simply means to buy back the short calls (the calls you sold) and sell calls with a lower strike price, and it is only done on a dropping stock. In our example, if the stock begins dropping, the trader might buy back the 20C and sell the 17.5C. As the stock drops, the short calls become cheaper, making it possible to buy them back for less than the amount received. By selling deeply in the money calls, you take in far more premium, which provides even greater downside protection. However, if rolling down provides no advantage, then there is no point doing it. For example, if you are looking at a $1.00 loss per share upon closing the position, yet you still will incur a $1.00 per share loss if you roll down to the current-month 17.5 call and are called out, there is no advantage in the roll. In this situation, you might have to roll out to the next month to get enough premium. In our $20 stock/20 Call example, when the stock falls to $19 there is no point rolling down yet. But if the market is selling off, you must consider it. Once the stock breaks through your $19 breakeven point, though, you must be considering a roll. I typically will start looking at possible rolls when the stock approaches the breakeven, using the CallWriter Trade Managment Calculator™, which gives me the result of doing a couple of different rolls with a mouse click. By the time the stock falls to $17.50, there is no point in rolling down, because there will not be enough premium (at that point the 17.5 would be at the money). The magic roll point in this example, then, is somewhere between the “target” 17.5 call strike and the $19 breakeven point. When should you roll down in this example? Without watching the prices, I cannot say. But by the time the stock reaches $18.50, you probably have to roll down. Below that it is highly unlikely there will be enough premium to make the roll profitable, and you will either have to roll down and further out in time, or close for a loss. The key is that there must be time value in the roll; time value is the profit. If the time value is too low, or worse the call is trading at or close to parity (intrinsic value), then the roll is not feasible. The goal is to roll down while there still is a profit in the trade. If there is no profit in a roll down, you are merely chasing the stock. I am always very loath to roll without picking up a small profit; I do much better when sticking to this rule. The following two examples illustrate the point about timing of the roll, using a slightly different example taken from a real trade: Example 1 Trade Action Amount Net Cost (Breakeven) Flat Return Called Return  Bought BUMM shares  -$ 21.10    Sold JUN 20 Calls  +$ 2.45  -$ 18.65 6.4% 6.4% Then stock drops to $18.80 as the market sells off. Closing the trade would yield a $0.05 per share loss, not including commissions.  Buy back JUN 20 Calls  -$    0.20  -$ 18.85  Sell JUN 17.5 Calls  +$    1.95  -$ 16.90     Return (Loss) +$    0.60 2.84% 2.84% This is not an uncommon example. In Example 1 the trader reacted adroitly, in time to roll down to the 17.5C and still get a positive return if called out of the stock at the new 17.5 strike As a result of the roll, the trader will, if called out at $17.50, still make $0.60 per share. This means the trader still can make nearly half the return originally expected even though the stock has taken a hit. Just as importantly, the trader has further reduced the original $18.65 cost basis (the breakeven point) to  $16.90, well below the new 17.5C strike.  That's good trading. And that is the power of rolling. Now see what happens when the trader waits too long to do the roll down: Example 2 Trade Action Amount Net Cost (Breakeven) Flat Return Called Return  Bought BUMM shares  -$ 21.10    Sold JUN 20 Calls  +$ 2.45  -$ 18.65 6.4% 6.4% Then stock drops to $18.20 as the market sells off. Closing the trade would yield a $0.60 per share loss, not including commissions.  Buy back JUN 20 Calls  -$    0.15  -$ 18.80  Sell JUN 17.5 Calls  +$    1.25  -$ 17.55     Return (Loss) -$    0.05 -0.24% -0.24% In Example 2, the trader waited too late. Rolling down at this point merely reduces the loss from $0.60 to $.05 per share, which is worth something. However, the roll only reduces the breakeven to $17.55. This trader is not in nearly as good a shape as in Example 1 - the less protected against further deterioration of the stock. This trader could, however, also roll out a month to the July calls and probably pick up an extra $0.40 - 0.50 in premium by doing so. But rolling out a month also increases the trade's expected duration. Better to work within the existing trade duration, when possible. One might, with some justification ask how on earth this trader could have known the stock would continue to deteriorate, and the answer is that no one can be sure. What I do is use the proprietary CallWriter Trade Management Calculator™, which shows me with a mouse click the results of rolling to any call I select. If I am concerned about the stock continuing to fall (and in a market correction, that is what I expect), I will roll to an advantageous strike in the same expiration month fairly quickly. Suppose in Example 1 the stock recovers and goes back up to the $20 range. The trader rolled down for nothing, ultimately. But first, the trader couldn't know it would recover. Second, even if the trader stays in the new 17.5-strike call he still will make money - a very important point when deciding whether or not to roll. Is there still a profit in the roll? When only the underlying stock is dropping, I prefer to see it breach a support point before I react to the move by rolling down. But when the market is selling off, I am much less inclined to hesitate. Rolling calls down protectively is something I will cover in depth in my upcoming series of Pick Wall Street’s Pockets Seminars. Attendees will actually get to manage dropping trades (virtual trades, of course), weigh the different alternatives under my tutelage and take action! It is a topic best learned live, by doing. I wish I had been able to take a seminar like this! Any one of several trades where I should have rolled and didn't would have paid for a seminar. #2: Buy a Protective Put This is the classic stratagem for a dropping stock. Simply buy a protective put. In our $20 stock/20 Call example, you would buy the put as soon as you perceive the market or the stock to be under pressure. You can always sell the put if events prove it unnecessary. But again, waiting until the stock is $15 means that buying the 15 Put will be far more expensive than it would have been if purchased when the stock was, say, $16.50 or $17 and was out of the money. As in rolling down, fortune rewards the early bird. The bad thing about buying the put is its cost. A really cheap put will be well out of the money and not offer anything more than protection against a catastrophic drop. A put that offers real protection on the other hand will be expensive. But that is trading; always the same cost/benefit trade-off. The long put offers another advantage that I never see covered writers talk about: if the stock drops but you decide the stock is solid and would prefer not to sell it, you can always sell the (now more valuable) put for a nice profit and just keep the stock. Keep in mind that the stock’s fall in price does not confer any tax advantage, while selling the put for a profit results in immediate income on the stock. Protective puts will also be covered (heck, naked puts, too) in my upcoming seminars. Although they are not a major feature of my trading strategy, they can be useful. #3: Go Naked Without question, the stock is the bitey end of the trade. The call is never the end that hurts you in a covered write – except when it keeps you from dumping a falling stock. The problem with simply selling an impaired stock in a covered call is that most traders must first buy back the short calls (the ones written) before being allowed to sell the stock. This is the case because selling the stock while the short calls are open would leave the calls naked, for which few traders have account approval. However, if the trader has the ability to sell the stock and leave the calls naked – and is willing on proper analysis to take the risk – this technique gets rid of a dropping stock and avoids the cost of buying the calls back. Or more to the point, going naked allows you to wait until the stock has dropped much further, making the call much cheaper to repurchase, without taking a hit on the stock as it drops. If the stock comes back while the naked calls are open, the call must be covered by repurchasing the stock or in some other manner, of course. Nothing is free of risk, but this is a technique that many seasoned (and well-heeled) writers will sometimes use. #4: Do Nothing One alternative when the market is selling off is to do nothing. Some readers might assume that this is the cop-out, head-in-the-sand alternative. But not really. If upon re-evaluating your trade while the market is falling, you decide the stock is sound, there are reasons to do nothing. First, you don't have to roll down or close the trade; you can merely buy back the short calls as the stock falls to get them out of the way. If you sold the calls for $1.00 and buy them back for $0.20, you've still picked up $0.80. Second, if the market finds support and comes back - which it has perhaps done twice now since the initial selloff, you can be whipsawed if you've rolled down to a lower strike and the stock recovers. This is why a roll down is problematical if the roll will not improve your position if called out at the lower strike. Third, there is some danger in selling calls on a stock significantly down if it has not established a convincing new trading range or trend. When for example a $30 stock has fallen to $20 and the trader writes the 20C on it, there is  an obivous problem if the stock recovers. Being called out at $20 would cement a loss, but the higher the stock goes, the more it costs to buy back the 20C. The trader has been whipsawed. The usual fix for this is to roll further out in time to a higher strike, as noted above. This can nicely solve the problem, but not always. Sometimes prices do not cooperate. Sure, you can write deeply in the money calls as the stock drops, even if there is no money in the roll, and you'll pick up a few bucks every time you buy back the ITM calls as the stock keeps falling. Just be ready to immediately buy the ITM calls back or roll out in time if the stock finds support or recovers in order to avoid the whipsaw. Fourth, sometimes the moment for advantageous action has passed and there is really nothing to do. This happens to all of us - don't kid yourself. If you have waited too late to roll down, no roll out in time appears satisfactory, and you have faith in the stock and don't want to close for a loss, then the thing to do is wait it out. My point is that immediate action is not the same as thoughtful action. Both exercised together is the ideal, but acting too quickly has probably hurt me more times than acting too slowly. A stock dropping on its own (showing weakness against the market) and one dropping with the market are two different things, admittedly. But the similarity they share is that the market can recover just as an individual stock can.   Stock Note: The "Evil" Rambus I cooked up this little note in response to several reader questions. No, Rambus (RMBS) isn't really evil; that's Microsoft, although some traders would disagree with me on Rambus right about now. But Rambus does give me a springboard to write briefly about a favorite topic of mine and yours - stock selection; it is to covered call trading what location is to real estate. On one of my TeleLab calls in early May, I was asked about Rambus, which at the time was around $45. In response, I noted that Rambus is a volatile stock that appears on our Real Time Lists™ fairly often, to the point that it seems almost odd when Rambus is not there and expressed the personal opinion that it is too volatile for my tastes. Not being a big tech stock fan in the first place, a tech stock that moves around as much as Rambus has no place in my covered call trading account. Within a week, Rambus had hit below $30, shot back above $46 and trended down from there. As I wrote this it was under $17 today due to an announcement that earnings will be restated. It may be a great stock for the long run; and perhaps a better buy for tech investors than it was at higher prices. But this, my friends, is not a good covered call stock. Among other things, Rambus is 1) rather volatile, subject to skitter around quite a lot - technical analysis is not much help with a stock that can move like this one; 2) even at these depressed prices, trading at a 65 P/E and 12.2 P/S (price to sales ratio) when the industry averages are 24 and 3.5, respectively; 3) one of the smaller companies in its industry, not a leader; and 4) a high-technology stock, not my favorite category, particularly when a market is correcting or uncertain. When the market sells off, there is a flight to quality stocks and out of flaky or over-priced stocks. Thus is a market correction, stocks like Rambus get double-hurt. Please, don't send me emails telling me how great Rambus is. I'm not saying it's a bad stock or knocking the company in any way. My point is that it is not a very good covered call stock. The essence of covered call stock selection is to choose the stocks that are the least likely to hurt you during the trade's short duration. With a volatile stock like Rambus, you are gambling that one of its selloffs does not occur on your watch. This issue's Question and Answer: The "High Premium" Covered Call Strategy Question:  CallWriter's lists focus on the highest-returning plays, but some covered call writers instead focus on using technical analysis techniques to write out-of-the-money calls. Why does CallWriter base its trading method on stocks with high call premium? Answer: Many covered writers, including myself, take the movement of the market or the stock into account; we all use technicals to one degree or another. I avoid stocks weaker than the market or hitting resistance, for example. I want a stock that, all things considered, has a fine-looking chart. But while I pay close attention to the technicals, they are just one of the decisional inputs. This sums it up: a poor technical picture certainly can keep me out of a covered call trade, but I will never enter one just because the technicals are strong. Purely technical covered call writing, in which the trader is trying to time the market, makes zero sense to me. If you are a good enough timer to consistently pick stocks about to advance, why on earth write covered calls? Why not just buy in-the-money calls and flip them when the stock makes its move? No matter how good you are at reading the tea leaves, you will often be wrong, getting the direction or the timing wrong; sometimes both. Timers expect to be wrong on as many as half of their trades (maybe more), and good ones make it up on the good trades that work. If one is good enough to consistently time stocks, why trade a strategy like covered calls that yields a fixed return? This is why I focus on high premium. I look for the best stocks with the highest call premiums, because I have found that this technique yields the best return, if trade selection is disciplined and trade management is practiced, results are very good, and the covered writer should seldom take a loss.

Good luck and good trading!