October 11, 2006

Covered Call Index: Bullish Strategy or
All-Weather Strategy?
by John Brasher, CallWriter Publisher

 

This theory assumes that covered calls are a neutral-to-bullish strategy and should only be written in a bullish market, ideally. Some writers allow that covered calls can be done in a neutral (ranging) market, but admonish us to be careful. Well, I try to be careful all the time. The main problem is that the "bullish" belief system assumes a lot. First, that covered writing in a bull market is somehow intrinsically safe. Yet my worst loss ever happened in a bull market. Believe me, you can write a disastrous stock in a great market. Think about this: we've been in an up market since back in January 2003 (although most of 2004 was ranging), yet many people took a hit when the market corrected in May 2006. Merely being in an uptrending market is no guarantee of success. Second, diagnosing exactly what the market is doing sometimes involves pure guesswork. For example, when a bear market ends and a new bull market (or at least a new uptrend) begins, it takes a while before it clearly is a bull movement - it could've just been a bear rally. You would miss a lot of a new uptrendt before deciding it is bullish. And who decides that it's a bull market, exactly? It takes forever for everyone to agree that it really is an up market, and by the point unanimity is achieved, the bull market is about over or getting long in the tooth. This isn't a very useful metric, is it? You know the old definition of pornography... we know it when we see it. Except we seem to disagree more about what the market is doing than whether a particular picture is pornography. Third, the bullish school assumes that covered writers are helpless if the stock is dropping. But the covered writer can write deeply in the money and can always roll down - the extremely high DITM premium gives huge downside protection. We can always roll down and out a month or so for fatter premium and more protection. I have found that by sticking to the strongest companies, writing a down market (except one that is correcting, obviously) can be done without much difficulty. Avoid stocks dropping against a good market, though. Fourth, Wall Street and many stock gurus pushing the buy-and-hold school of stock investing exhort us to hold on to "good stocks" through thick and thin; they say don't cut and run just because the stock is down with the market, in other words. But they also tell us that covered calls, by definition a strategy involving short-term trades that give the stock much less time to hurt us, are dangerous in down markets. How can writing the best companies in a down market be more dangerous than holding on to them during their entire drop through a bear market phase? If the stock goes down on the covered writer more than anticipated, can't the covered writer hold onto them, just like the stock investor, but unlike the stock investor keep wringing premium out of them... writing deep ITM calls and them buying them back, rolling the calls down with the stock's decline? Of course we can. Unlike the investor, though, we're pulling an income out the asset. Fifth, it ignores the fact that there always are stocks outperforming a declining market. For example, many stocks took a hit beginning the second week of May 2006 when the market corrected. But some stocks took a very small hit and quickly recovered. Many stocks, though, especially the tech stocks and the weak companies, took a big hit, and many have not come back. When institutional investors get nervous, there is a flight to quality out of weaker stocks. So tech stocks got a double whammy - they got hit by the pullback and hit again as money drained out of them into better, more boring companies. Stock selection matters greatly... being in a bull market is no justification for assuming that tomorrow will be as good as today. Here's another example you'll enjoy: In 2002 I had occasion to print out one of the Real Time Lists™ (the S&P 100 list), four weeks before expiration. Back then the list only had 15 trades on it - today there are as many as 30 - and there was one duplicate, so it featured 14 different stocks. In that four-week period the Dow Jones Industrial Averages lost 1,000 points. Yet 12 of the 14 trades won outright at expiration and the other two could easily have been managed without a loss. Look at an INDU chart for mid-2002 and you'll see what I mean. I think the "bull market" dictum is not a useful piece of advice. It flies in the face of my direct experience, and the experience of many of our long-term members. Sure, it's great to write in a bull market (just remember May 2006, though), but it's not the only time we can write. We covered call writers are lucky that way. *  *  * I know that it's not easy to learn covered call writing from a book or web page. Even though CallWriter offers more content on covered call writing (much of it freely available to all) than anyone, even sites like CBOE, web pages don't provide dynamic instruction. If you really want to learn how to get consistent success at covered calls, please come to one of my seminars. You'll leave them knowing how to write covered calls properly. And if you're unsatisfied at one of my seminars, we have a money-back guarantee - which no one has ever asked for. Please pardon the commercial, but I talk to people all the time who go to seminars on trading, some of them horrendously expensive, but who haven't even learned how to pick a trade. And even after taking a lot of your money, some of these companies charge high fees for access to tools and information on their websites. Not CallWriter. For one low monthly charge, you get everything on our website, no holding back. Insider Transactions: I came across an interesting article by Mark Hulbert featured in MarketWatch about insider transactions recently. As you may know, strong insider selling can be a warning about the stock or the market. Whenever a company's fortunes dim, we always see a pattern of massive insider selling back down the road, sometimes more than a year before the negative news is released. They know. Corporate insiders also have a much better handle than the public on the economy, so a major downturn in the market usually is preceded by massive insider selling as they batten the hatches and take money off the table. The stock market is perhaps THE leading economic indicator, and usually rises (falls) many months before an economic upturn (downturn). It's harder to read the tea leaves of insider transactions now than in years previous, because such a huge percentage of insider compensation nowadays comes in the form of stock. They naturally sell more when the market is really up, to get the best price, the same as anyone else. But insiders vote with their feet. Whether they're staying or going is indicative of what they really think. Hulbert quotes Professor Nejat Seyhun of the University of Michigan, who studies insiders' behavior, who notes that the normal ratio of insider selling to buying these days is about 6.5 to 1. The current ratio is only 3.2 to one, less than half the norm - and even that is down from the week before. So insiders are not particularly nervous about the economy. This is no guarantee the market will range where it is, and it's certainly no guarantee it wil continue to rise. But the savviest folks in the land are not running for the exits, and that is some comfort about the economy and the stock market.