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June 10, 2005
CallWriter's MADI:
Using Moving Averages in Covered Call Writing
by John Brasher, CallWriter Publisher
| Moving averages can be
very helpful in virtually all types of trading, including
covered call writing. We use a specialized version of moving
averages right on our Real Time Lists™ of the highest-returning
covered calls. This article will show you how to energize
your trading results and cut the time needed to analyze potential
covered call trades. |
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A moving average (MA) is simply a line on a price
chart showing the stock's average price over time in relation to
price bars, with price variations smoothed to a single line. Traders
figured out long ago that the moving average can be highly significant
in all types of trading activity. The purpose of this article is
not to teach the use of moving averages but to show how we have
integrated them into our Real Time Lists™ so that you can
use them (as we do) in analyzing trades on the lists.
Since there is no way to overlay moving averages
onto the Real Time Lists™, we instead chose to represent the
14-day and 50-day moving averages as numbers on the lists. We invented
the MADI (moving average directional indicator),
an oscillator signal expressed in percentage form that indicates
how far the current stock price is off the 14-day or 50-day moving
average. A MADI of “00” means that the current price
is flat compared to the moving average and indicates sideways price
movement. This does not mean the price has remained flat during
the entire measurement period, and it could in fact have moved up
or down during the period. The “00” value means only
that the current price is approximately at the moving average.
Each MADI point roughly corresponds to a 2% price
movement. A value of "05" indicates that the current price
is 10% higher than the moving average, and "-05" indicates
that it is 10% lower. Values outside of the +/-10 range indicate
a fair degree of movement. The 50-MA is far more significant than
the 14-MA, because the 14 is a bit too reactive and conveys less
valuable information. For example, a stock with a 50-MADI of -10
has dropped far below the 50-MA, and it really would not matter
to me what the 14-MADI is doing, because I would not likely touch
the stock. Conversely, if the 50-MADI is strong, I would not necessarily
be put off by a negative 14-MADI, unless it was greater than -05,
because the stock still is showing strength on the 50-day average.
The three moving averages that we use primarily
are the 14-day (14-MA), 50-day and 200-day. There are many others,
but these are commonly used. For brevity, we only show the 14-MA
and 50-MA on the Real Time Lists™. A frequent question from
our members is how to cut the analysis time for evaluating potential
trades, and the MADI is a good tool for speeding analysis without
sacrificing due care. For readers who are not CallWriter members,
we provide a sample
list with one current covered call trade featured that demonstrates
the MADI.
MADI
is Up,
Market is Up |
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Stock is moving with its index,
which is the norm for a stock that moves with the market. This
only tells you that the stock is not weak, not that it is a
good covered call candidate. For a more detailed analysis of
what the MADI is telling you, see the following section. |
MADI
is Up,
Market is Down |
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The stock is showing more, perhaps significantly
more, strength than the market. This is a good sign and warrants
further analysis. |
MADI
is Down,
Market is Down |
|
The stock is moving with its index, which is
the norm for a stock that moves with the market. The bad news
is that the stock is no stronger than the market, and you can
perhaps do better. |
MADI
is Down,
Market is Up |
|
The stock is weaker than the market, not a
good sign. While a deeply in-the-money call on this stock might
work, it would never be a very compelling trade, since there
will almost always be better trades. |
| 14-MA
and 50-MA both are the same value |
|
Indicates the two moving averages
have converged and that a moving-average crossover of the 14-MA
above or below the 50-MA may be imminent. Or it can simply mean
that the stock is in a narrow trading range. |
| 14-MA
and 50-MA both are 00 |
|
Generally indicates that the stock is in a
trading range or slight downtrend, with an RSI of 55 or less. |
| 14-MA
is down,
50-MA is 00 or -01 |
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The stock has pulled back recently but
at the moment is holding or at least testing the 50-MA. This
may indicate a negative crossover in which the 14-MA is crossing
below the 50-MA.
We typically do not write these in a flat
or rising market, since we want to see a successful test of
the 50-MA and a new advance - that is, a bounce off the 50. |
14-MA
is up,
50-MA is down |
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The stock has advanced recently but has not
moved up enough to rise above the 50-MA. I want to see the stock
move above the 50-MA in order to be sure that the 50-MA will
not act as a resistance level. |
| Both
the 14-MA and 50-MA are up |
|
The stock is advancing, and the bigger the
numbers the stronger the advance. If the 50-MADI is above 10,
I would look carefully at the chart to see if a pullback is
in order. |
| Both
the 14-MA and 50-MA are down |
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The stock has been selling off and probably
has an RSI of 40 or below. Unless it catches support at the
100- or 200-MA and starts a new advance, its decline can be
expected to continue. This generally indicates a stock to avoid
in a flat or rising market. |
Moving averages are not the end-all of trading.
Other factors such as support and resistance remain important. For
example, I will not normally consider writing a stock that is hitting
or about to hit a meaningful resistance level, because I expect
a pullback. Similarly, a stock with a negative 50-MADI might be
finding support at the 100- or 200-MA and be ready for a new advance,
in which case an out-of-the-money call may be in order.
Although it is conventional Wall Street "wisdom"
that one does not write covered calls in a declining market, we
have not found this to be true, necessarily. What IS true is that
you'd best not write when the market is in a steep decline or collapsing.
When the market is in a more moderate decline, writing is not especially
hazardous if you are careful and disciplined. How can this be? First,
when a strong stock is in a moderate decline, it is not difficult
to write it deeply in the money.
Second, not all stocks
decline in a down market. There are virtually always stocks that
are holding price or even advancing in a market decline, just as
there are doggy stocks in a bull market. Strong stocks in a down
market are a delightful thing for covered writers.
The dynamics of using moving averages change with
market conditions. As an example, it is universally believed that
a covered call stock should be above its 200-MA, since it is a sign
of weakness to be below it. However, that is only true in flat or
rising markets. In a prolonged bear market, pretty much every stock
might be below the 200-MA, in which case it no longer acts as a
guideline. In such case, you can't use the 200-MA as a reference
except when a stock below the 200-MA breaks above it. By the same
token, in a bull market (or during a bear rally in a down market),
virtually every stock might be above the 200-MA, in which case being
above the 200-MA is not so much evidence of strength as being below
it is evidence of weakness. When the market has been declining,
the 50-MA becomes that much more important, and really separates
the stronger stocks from the weaker.
The MADI cannot show you the stock's trading history,
nor will it indicate a technical pattern forming. The MADI thus
is not a primary trading signal, and its best use is to indicate
whether further evaluation of a trade candidate is justified. For
example, a MADI of 07:01 may indicate that a stock
trading in a very flat range has recently spiked up; or it may indicate
that a stock which has been down has recently surged and has only
now crossed the 50-MA. That is, the same combination of MADI numbers
do not always mean the same thing or indicate the same technical
picture.
If uncertain what the MADI is telling you, simply
pull up a chart on the stock (which you can do instantly from the
Real Time Lists™) and check what you are seeing against the
MADI. With surprisingly little practice, you will learn to picture
the stock's recent price movement from simply viewing the MADI,
with a fair degree of accuracy.
Before you even think about trading, know what the
market is doing. Look at daily charts on the Dow Jones Industrial
Averages, the S&P 500 Index and the Nasdaq Composite Index and
know what their charts look like. Without this knowledge, the MADI
- and moving averages in general - have little meaning, since you
cannot analyze a stock in a vacuum. You must know what the stock's
index is doing.
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