Do you use moving averages, and which ones?

I keep it simple, generally, since I really believe that too much information leads to analysis paralysis. The only place I sort of violate that is in using moving averages. I use a combination of the 14, 50- and 200-day moving averages. Some find three averages on one chart bewildering or too cluttered, but that is why every trader has a different style. The combination of the 20- and 40-day or 20- and 50-day averages can work well, also. Some stocks work better with one than another.

I like the longer-period 200-MA to get a sense of the stock's relationship to its major trend. If the stock has been ranging for a while it may be far above or below the longer-period MA, in which case that MA will be largely irrelevant. But sometimes a stock will fall significantly below the 50-MA, in which case I want to see the stock find support at the 200-MA (or the 100-MA); if it does, I may like the stock technically at the point support is confirmed. On the other hand, when a rising stock has left the 50-MA behind, I would not touch it if approaching the 200-MA (or perhaps the 100-MA), which could act as a resistance level. The stock might be more reactive to the 100- or 200-MA, and you have to look to see which.

I'm not a purely technical trader, so I am not looking for positive moving average crossovers (ex: the 14-MA is crossing above the 50-MA) necessarily, but in a good market will avoid negative crossovers. In a prolonged down market, most stocks will be down, so I look for MA scenarios that are good in relation to the current market. When the market has been up or down for a prolonged period, I go to the 100-MA, because most stocks will be so far above or below the 200-MA that it has little utility, an example of adjusting to market conditions. I use the simple MA, though the exponential moving average (which gives more weight to recent prices) can work fine - I just prefer the unmassaged data. Neither is right or wrong.

Any moving average can act as support or resistance. Check the stock's history to see if price is particularly reactive to a moving average. If it is not reactive to any MA you are using, you may not have the right ones; or the stock just might be one that does not react with moving averages - these worry me, because I can't get my arms around them. Of course, a stock's interaction with moving averages can change over time. Nothing is forever in technical analysis.

Do trend lines have a place in your technical analysis?

You bet. It is just one of the tools in the toolkit. When looking at a stock from a technical perspective, I want to know what pattern or trend is present - is it trending, ranging or making some other known chart formation? Sometimes the trend lines will show you things that are not apparent otherwise.

What technical indicators do you use?

I'm a big believer in volume. It don't mean a thing if it ain't got that swing, so I always have a volume histogram under the price chart. A price trend up or down should be confirmed by increasing volume. An upward movement on flat or dropping volume is bearish, and a move down on flat or especially dropping volume is bullish. I pay particular attention to volume surges that are greater in magnitude and duration than usual, since when they occur at a resistance or support level it can herald a reversal, which often can lead other indicators by as much as a week. (Finding such volume surges is the purpose of the MADI on our lists). Hint: if you can overlay a moving average on the volume histogram itself, you can see some very interesting things!

Sometimes I look at On Balance Volume for an idea of whether money is flowing into or out of the stock, just for further confirmation, but actual volume is the primary signal. OBV should be rising or falling with the stock, whereas the volume histogram should show increasing volume on both up and down trends.

Regarding indicators, I like the MACD (moving average convergence-divergence) on a trending stock, and prefer the RSI (Wilder's relative strength indicator), an overbought-oversold indicator, on ranging stocks. The MACD is close to useless on a ranging stock because it lags too much, but is good on trending stocks. For some reason, the MACD seems much more reliable on a weekly chart than daily or even shorter charts. The PPI appears to be essentially identical to the MACD. The RSI isn't very good for a trending stock, since it gives too many false overbought signals on rising stocks and false oversold signals on falling stocks. Stocks in a trend don't care about RSI and other OB/OS indicators! Similar oscillators like the stochastic can work well, too; I just started out using the RSI and have stuck with it. There is no best, only what works best for you.

Remember that you can draw trend lines on these indicators and the volume histogram, which can reveal an otherwise hidden trend in the indicator's activity.

What chart time period do you use? I use as many as three different chart periods: daily, weekly and hour (60-minute). My base chart is the daily, with either six months or a year of data, since I am usually looking for short-term trades. If I like the look of the daily chart, I will check the stock on a weekly chart, to get an idea of the major trend. For example, the stock might show you a lovely up-leg on a daily chart but, when viewed on the weekly chart, reveal that the price really is moving back up to test the trend line - resistance. Sometimes I look at an hour chart as well. The stock can look OK on the daily but be tipping over on the 60-minute, in which case you'd better look at the stock far more carefully, since the 60-minute chart is very predictive out to 10 days or so.

The best bet is a stock showing strength on all three. The bigger and more established the company, the less likely I am to consult the hour chart.

What is your opinion of Japanese candlesticks?

I use the candlestick-style chart, but I don't use sticks in technical analysis. I'm not really a technical trader, so classical candlestick analysis is not that useful for me. It is a good skill to have, no doubt, but every time I try to sit down and learn it I seem to get tied up in knots. Like point and figure (P&F) charts, stick analysis doesn't mesh with the way my mind works. If you find it helpful, use it by all means. For covered call writers, I suspect it is more of a confirming signal than a primary trading signal. It would be interesting to apply stock analysis to a weekly chart and see if it has any utility there.

Do trades ever give you the cold sweats?

Not really (it used to happen), but my heart can race. I am analytical by nature, so when a stock is moving adversely to my expectations, I will look for the reason: pending news that I missed, unexpected news out of the blue, negative earnings guidance, whatever. Then I decide what to do: whether to close the trade, roll the calls or take other action. For me an adverse move is a challenge, like a chess match; I don't look forward to it, but since it will happen to every trader sooner or later, that is a good mindset to adopt. Bottom line, though, I really don't write the kind of stocks that give one the cold sweats, which is probably why I don't get them. When I used to write crummy stocks it happened a lot.

What is your process for analyzing a trade?

My philosophy is to spend as little time as possible on each trade, especially ones that don't cut the mustard. Thus my process is geared to disqualify a non-starter trade as quickly as I can and focus on do-able trades. I look first at the information on our Real Time Lists™, which have been designed to present information that helps you to quickly qualify or disqualify a trade, such as profitability and average daily volume, industry and moving averages.

If nothing in the list data puts me off, I check to see if earnings are coming before expiration. This may not disqualify the trade, but it affects my analysis. I look at technical data first: the chart, volume, indicators and such. While a good technical picture is not enough of a justification to enter a trade, poor technicals certainly will keep me out of one. If earnings are coming, then I look for the company's preannouncements on earnings and look to see how the stock typically reacts to earnings - whether it sells off on earnings, etc. If the stock has run up on earnings anticipation, I am much more cautious and would either pass on the stock or only be willing to write it deep in the money assuming ITM was worthwhile. I generally will pass on earnings plays except companies that have a history of strong earnings growth over the last couple of years. The big danger in earnings plays is the possibility that the company will provide negative guidance for the future, which it always does in the earnings release. You cannot predict negative guidance in advance, and the stock's "typical" reaction to earnings is not a guide to how big a hit the stock will take on issuing negative guidance. It is a risk you take in earnings plays, pure and simple.

If the technicals look good, and either earnings are not due before expiration or earnings will be reported and I am comfortable with the risk, then I look at the fundamentals. The fundamentals need not take a lot of time, but why go there if an earnings report or poor technicals would keep you out of the trade?

Only if the fundamentals are satisfactory do I look for news, which is the most time-consuming part of the process and is covered separately below.

Other covered call "gurus" don't look at news, so why do you?

First, thanks for the guru tag. In a word, major news on the stock will always trump the chart. No matter how well the company is doing, or how pretty the chart, major news can move the stock without regard to the chart. The bigger the news in relation to the company's size and prospects, the greater the risk (and the less relevant the chart history becomes). If you are not looking for news, you had better be sticking to big board stocks. Ignore the general news items, particularly the ones that discuss numerous stocks (e.g., Man Financial releases) and look for press releases by the company, which are usually Business Wire or PRWeb releases. You can also get press releases from the company's site. You might want to look at a few general news items to see if news on the company turns up, or get a feel for the market's view of the company, but I usually don't find anything very concrete there.

Remember that premium is high for a reason, and the reason is that the market - based on some pending event - thinks that the stock may be about to move. This means that news or some event affecting the stock is coming. Stocks with high premium usually do not move materially, but you are much better off to know what is driving premium high.

Why are you against small companies and tech companies?

Small companies and tech companies... how do I hate thee? Let me count the ways. Seriously, small companies are dangerous and their prices easily manipulated; they are subject to big price movements. Tech companies on the Nasdaq tend to break up or down far more than big board stocks, which is great for directional traders, but not so good for covered call writers. The large tech companies can be good writes, but I prefer it if they have taken a spanking in recent times and established a new and lower trading range. The market has not for several years liked or trusted tech as a general rule, which is why the Nasdaq has performed so woefully during this bull market. If you write tech, stick to the Nasdaq 100 or techs on the big board.

I'm conservative in stock selection because most of the real drubbings I've taken have been from smaller companies, or unprofitable companies, or tech companies. Worse of all, of course, is the unprofitable small tech company.

Do you really use the CallWriter lists and calculator in your writing?

Yes! They are pretty much all I use for covered call writing, and I use the very same lists and calculator available to you on the CallWriter members' website. I also find other trades (bull put spreads, bear call spreads, etc.) from out lists. If there was, in my opinion, a better covered call site, I would either duplicate it or use it.

What are the secrets to covered call success?

Knowledge, enjoyment and discipline. If you don't enjoy trading, you'll likely never be very good at it and you will find it stressful. In Wall Street parlance, you will be trading "scared money." I love trading, and every successful covered call writer I know (or other trader) really enjoys it. If you really don't like it or find it a grind, then trading is not for you. Be honest with yourself about this.

You must trade with discipline. Violate one of your rules, then you'll start violating others. Pretty soon, you'll be trading hunches! Stick to your guns, do the necessary research, re-evaluate trades that surprise you, don't panic. Trading should be cool, reflective and decisive, not emotional. If you are trading for excitement (as opposed to having a passion for it), consider the craps or poker tables instead. A related point is that everyone is geared differently, and you should trade in accordance with your personality. There are a lot of trading styles, and if yours doesn't match your personality you won't be as successful (maybe not successful at all) and certainly won't enjoy it. For example, some people want to make money trading but don't want to take the time to write covered calls every month because it's too much work . The good thing about covered calls is that there is a writing style for just about every personality.

Knowledge is the hard part for a lot of people. In the case of covered call writers, they often do very well starting out only to have one trade go disastrously - or have several fall when the market pulls back like it did in May 2006. The result many times is that the trader either is out of money by the time he or she gets sea legs, or the trader runs away scalded and decides this covered call writing stuff is hooey. Traders frequently just don't know how to find or select good trades, how to construct them or how to react to price movements. They either don't react to movements when they should, or do the wrong thing. This is why I started doing seminars again. People need the knowledge. It's astonishing the difference a good seminar makes in covered call writing. But however, you get the knowledge, it is imperative that you do. The school of hard knocks works well, too, if you have the trading capital to afford it.

Do you view trading as a business?

Yes, yes and yes. That is the only way to view it. If trading is not a business then it must be a hobby. If you put the same money into a Taco Bell franchise instead of a trading account, would you make decisions based on emotion or calculation? Would you rush into a new business and spend or risk lots of your money without doing plenty of research and learning all you can? You shouldn't, but many people do, which is why half or so of all new businesses fail. Many traders fail for precisely the same reason - see knowledge, enjoyment and discipline comments above. Trading is a business and should be approached with commitment and resolve.

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I hope the holidays have been great for all of you. Next year will see some cool changes in CallWriter, more TeleLabs for members, other great things. I wish all of you a happy and prosperous new year.

John Brasher, Publisher
CallWriter.com

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