April 17, 2007

When a Stock Pulls Back
by John Brasher, CallWriter Publisher

You write a covered call on a stock and the next thing you know, it's pulling back. What to do? The situation may not be all that bad and may not be a problem at all. Don't cause yourself a problem where there wasn't one!

The Pullback and the Chart A member recently wrote with concerns about Network Appliance  (NTAP), which has been in an uptrend since July 2006 and has recently pulled back. She got into the stock about a month ago, it has continued to drop, and she is wondering how to handle the stock or to cut losses and get out. A quick look satisfied me that NTAP is a good company; growth, profitability and financial health scores are excellent, and far better than industry average - only Apple grades better. Volume is strong, and overall NTAP is a good company on which to write a covered call. First, as always, we look at a chart. I start with a daily chart but also look at a weekly chart in order to get the bigger picture. In this case, the weekly really tells the tale: NTAP is in a long-term uptrend; not a sharp one but still an uptrend. It has pulled back to the trendline three times. The 100-MA acts as support also, but the trendline is even sharper support. It is pulling back again and I would expect it to pull all the way back to about the 32.50 level, the 100-MA. Note that the MACD peaks have been downtrending since late 2004 as the stock price has risen, an interesting bearish divergence. It is also interesting that we don't see volume increases as the price snaps back off the lows, also a bearish sign. Nevertheless, the trend is what it is; 27 months of uptrend convinces me. Importantly, notice that the amplitude of the waves - tops to bottoms - in this stock is fairly long. The shortest time frame from support to top seems to be over 45 days, which is plenty of time to react with the stock's movement. Handling the Pullback So how to handle a stock when you write at the top of a wave or (as our member did) once a pullback has begun? First, don't panic. Stocks in an uptrend do this. Unless NTAP convincingly breaks trendline support (about $32), we can assume the trend remains intact. Earnings are not due out again until May 16th, so they are not currently an issue. When a stock is pulling back, the premium of the short call (the one you sold) will fall also - OTM calls, with their much lower delta, will fall less rapidly than ATM or ITM strikes. One approach is to buy back the short call for less than the price paid (which adds a credit to the transaction stream) and write a further ITM call. This is known as rolling the calls down, which is done to get more premium to compensate for the stock's drop. Because we can reasonably expect NTAP to find support at about the $32 level, care must be taken not to get trapped in a 32.5 or 35 Call, which may put the writer in the assignment squeeze - forcing the writer to either allow assignment at those low strikes and lock in a loss, or buy back the calls as the stock moves back up in order to avoid assignment - which will involve creating debits (bad). It goes without saying that at this point in time it would be illogical to write a call strike below the $32 support level, because it is asking to be caught in the assignment squeeze. Remember the great old WWII movie "A Bridge Too Far"? Well, don't roll down a strike too far, which is easy to do. Care must be taken in rolling down, and it works best when the stock is in a rolling pattern and you begin rolling it down as the stock fails again at the resistance level. You would continue rolling the calls down with the stock, being careful not to write a strike at or below the support level. Since ranging stocks do not always reliably fall all the way back to the bottom of the channel, you must be prepared to buy back the new ITM call if the stock begins a new advance. I hate adding debits in a position, but it sometimes is part of the covered call game - especially when you roll down a lot. When a stock is in a clear uptrend and temporarily pulling back, be careful to 1) not write a strike below support and 2) monitor to stock so as to close the ITM call when the stock finds support so as to not get caught in the assignment squeeze. The Alternatives to Rolling Down Rather than rolling down, is possible to roll the calls out further in time to get more premium. NTAP has both MAY and JUN calls available now, so the call writer is in the catbird seat. The MAY and JUN 35 and 37.5 calls offer good premium which is mostly time value, meaning that time decay will work in your favor. The benefits of writing the higher calls further out is that they are less likely to put you in the assignment squeeze. There is more time for the trades to resolve favorably (the long amplitude discussed above), and the fact that they are mostly time value means that they are likely to much cheaper to buy back in a few weeks, unless the stock's recovery puts them in the money. You could buy a protective put on NTAP if truly concerned that this pullback isn't temporary. In fact, you might consider buying a put even if you are dead sure the stock is only pulling back to the trendline. Assuming that you buy an ITM put, it will gain in value dollar-for-dollar with the stock as it continues to fall. An ATM put will not gain in value quite the same until it, too, becomes solidly ITM. The beauty of this strategy is that if the stock finds the predicted support, you sell the now-more-valuable put for a nice profit, perhaps a very nice profit. Such a put is truly protective but also a profit opportunity. If the stock does not continue to fall as expected, close the put, of course. Anyone seeing a good bear call (credit) spread here? When a stock is falling, it can be the perfect time to work in a quick OTM bear call spread, just as an OTM bull put (credit) spread can work great when a stock has bottomed and appears to have begun a solid new advance. In other words, don't be wedded solely to covered call writing when a stock shows you another great trade. The point of trading is to make money money off the stock. Other strategies can work on a stock instead of - or even in tandem with - a covered call position. The important thing is to not get spooked and to work with what the stock is showing you. While there certainly is no guarantee NTAP will find support this time, or even that the market will hold, acting on such a strong chart is reasonable and better than taking a loss out of fear. How About ATI? Now take a look at Allegheny Technologies (ATI). See any similarities in the daily ATI chart below to the NTAP weekly chart above? ATI has had the habit for some time now of pulling back to the trendline/50-MA, and appears likely to do so again soon. I'm guessing it has a little higher to go before a real pullback, judging from its history. On the other hand, with the market back looking for that all-time high again, we can be sure of nothing. Assuming no major movement in the market, however, we can safely assume that ATI will pullback in the near future.  But if an apparent pullback begins, don't be too quick to roll down or out. Notice how ATI seemed to be beginning a nice pullback a few days ago and then snapped back to a new high. Anyone who closed out a short call and then rewrote the call as the price recovered to the high made a nice little profit. Yup, this is an old trading strategy - buying back calls when the stock dips, then selling the calls again when the stock snaps back - and it works as well as it always has. If the stock doesn't snap back, you simply don't write the same call again. Write further down or further out, whatever shows you the most advantage in light of the chart and call premiums. On the other hand, anyone who rolled ATI down to a lower strike April call is now looking at having to buy it back to avoid assignment. In addition to not being too quick on the trigger, be very careful about rolling down in the same month when there is not much time left until expiration. Moral of the story: when writing good companies, don't be too quick on the trigger to roll or otherwise react. If the trade appears to be setting up a nice little profit, don't hesitate to take it. But reacting too quickly can put you in the position of daytrading calls - not usually a good practice. This is why successful call writers stick to good stocks in the first place. We can pull a few extra bucks out of a stock like ATI and have some fun with it, without having the beejesus scared out of us.

Good luck and good trading!