November 7, 2003

Stop, Look and Listen:
Heed what the stock is telling you.
By John Brasher, CallWriter Publisher

It happens to every trader now and then: you rush into a good trade and it kills you. We frequently get the question of how to avoid getting stomped by a stock that seemed so profitable and so friendly going in. In today's newsletter, we take a look at a trade in BioPure (BPUR), which presented fat covered call profits the 3rd week in October. Then one morning it gapped down hard on the open on unforeseen (and unforeseeable) news. It blew right through a stop price and handed the trader a 50% loss despite the stop. Question is, could the loss have been avoided?

Sometimes, avoiding the loss means avoiding the trade...

This situation illustrates the problem with relying on stop limit orders and stop orders. Stocks dropping hard blow right through them. In fact, a stock under severe pressure might, like BPUR, gap down on the open (meaning the opening price is lower, maybe much lower, than the previous day's close), making any kind of stop ineffective to prevent a loss. Once you see the news, of course, there is no real time to react. Stocks can hand you a catastrophic loss, and care is due in each and every trade. Traders frequently ask us for "silver bullet" trading secrets, but there aren't any. And nothing really works when a stock gaps down on the open. But sometimes the only way to avoid a likely loss is to size up the stock and avoid the position in the first place.

First, keep in mind that stocks are on our Real Time Lists™ of the highest returning covered call plays for a reason, and sometimes the reason is that they pose a dangerous level of volatility. What is interesting is that BPUR had huge support at the $5.50 level and ignored it and that there was no warning news before the bad news came out. Before launching into the analysis, let's examine whether a protective put would have helped.

Would buying a protective put have helped?
Nah.

One question we get a lot is whether a protective put (buying a put) is a good idea or would have prevented a loss. The answer is: not usually. Long puts cost money, which means that they are economically feasible only if bought well out of the money, in which case they only protect against catastrophic losses. On a $20 stock, for example, one might buy the 17.5 or 15 put, since they might be cheap enough to leave an acceptable covered call profit. The 17.5 put on a $20 stock would offer real protection but its cost probably would leave little covered call profit. The 15 strike put would be much cheaper and might leave an acceptable call profit, but would still leave the trader open to a 25% loss if the stock dropped below $15 and you had to exercise the 15 put. So you either have to give away most of your return from writing the calls to buy the protective put that is reasonably close to the money, or buy a cheap put well out of the money that still will leave you with a serious loss. Not much of a bargain!

Stocks under $10, however, can drop several dollars rapidly, even fall by half or more. While this would hurt even on a $20 stock, it is absolutely catastrophic on a cheaper stock, which is what happened to BPUR: it dropped from $5.89 to $2.80 (over 50%) in just one day. Buying puts on a stock under $10 is not usually an effective strategy since really protective put strikes cost too much, and a put one or two strikes out of the money still exposes you to as much as a 50% loss, so what's the point?

Our CallWriter trades win almost all the time, and we never buy protective puts. Why? We rely on our skill at technical analysis and have learned some important ground rules that yield consistent profits on our covered call and spread trades. Like any successful coach will tell you, the key is to STICK TO THE BASICS, meaning to develop sensible trading rules and don't violate them.

Want to avoid getting killed in trades? If so, here's the real secret: look at the information that's important. We know that when many inexperienced traders write a covered call they are not looking at information that we at CallWriter consider critical.

1. Look at the stock's earnings.
BPUR has no earnings and loses money like crazy. Small stocks like this have no spine, and bad news can send them down catastrophically. We almost always avoid stocks like this, because what happened to the trader in our BPUR example has also happened to us! We've gotten caught, too. If you consistently write garbage stocks to get a high return, you will get hurt.

2. Look at the moving averages.
BPUR had already been dropping and on Sept. 26th on a daily chart the 14-day moving average (14 MA) crossed below the 50 MA, a very bearish development. Then on 10-02, the 14 MA crossed below the 100 MA, even more bearish. This shows a stock in serious decline. At the same time, there was no news in the market indicating a reason for the decline. These are all bad signs. When the stock is strongly advancing or declining, you want to know why and if you can't find a reason, consider that other players in the market might know something you don't. Consider the following chart:

BPUR Chart 11/07/2003

Notice how the stock first fell below the 14-day moving average (14 MA) on September 15th and just got worse and worse. If you had written this stock before Sept. 15th, you would not have had the warning reflected on the above chart, but you would have known it is a lousy, money-losing stock. This is why, for us at CallWriter, avoiding lousy stocks is rule no. 1.

3.  Check for news.
On biotech and biopharm stocks which could have FDA approval hearings pending, looking for news is life and death for a trader. We emphasize, stocks are on our Real Time Lists™ for a reason. A negative FDA action can kill a small stock and hurt even a big one. BPUR is a small company attempting to develop an artificial blood substitute and will live or die based upon how the FDA rules. The FDA staff asked for extensive information about the blood substitute products, which would take months to dig up, and BPUR laid off 30% of employees to get through the additional time the inquiry will add to its product development time. In fact, the FDA inquiry alone was enough to knock BPUR to its knees. But in BPUR's case, looking for news would not have helped you, since there was no news in the market to get. (Obviously, someone knew something, because there otherwise is no justification for BPUR's decline during a strong market) You may be thinking, what can a trader do? What's the good of looking for news when there isn't any?

Answer: go back to Rule 1!! BPUR actually was telling the careful trader several very important things:

The perennial operating losses revealed that this was a dangerous stock to write no matter how pretty the chart might have been at the time. In fact, this is a money losing company whose future hinges on its artificial blood product, and you now know how dangerous little companies like this can be. The chart after September 15th made clear that BPUR was was in decline, a stock to run from. The lack of news that would explain a price decline coupled with the decline constituted a creepy and real danger signal.

See what we mean in saying that BPUR really was talking to traders and conveying important information? A good stock can go bad; it happens. Sometimes, no matter how frosty your trading is, stocks just deal you a loss. But you can greatly reduce losses in your trading and in fact almost eliminate them by following the simple rules above:

• Stay away from money losing stocks, especially the small ones.
• Stay away from stocks violating or about to violate a moving average.
• Stay away from stocks that are declining for no discernible reason.

The important thing in any loss is not the loss itself but to avoid becoming discouraged and to learn from it. Use each negative experience as a tool that transforms your trading process into a frosty process where you pull the trigger only when you're pretty dead sure of hitting the target. Remember, our Real Time Lists™ always have good trade candidates, which frees you to pass up on the iffy ones. If you don't see any trades you like on a particular day, then don't trade. Develop a set of entry and exit guidelines that work for you and stay with them.

Good luck and good trading!