Do the right thing...

The purpose of this kind of newsletter is so that you can learn from our actual trading activity. Here are the trade details:

This trade was a covered call on biopharmaceutical company Genta Corp. (GNTA), in which shares of GNTA were purchased for $16.60 and the GNTA September 15 call option was sold for a $3 premium. This means the GNTA covered call trade got filled at a net debit of $13.60 - the amount taken out of a trader's account. This was a deep-in-the-money (DITM) call, since the $15 strike price was $1.60 below the stock price. The $3.00 premium protected traders down to about $13.60, the breakeven point. The trade wound up technically a $0.14 winner before trade costs. Well, a trade that ends like this one is a lot better than a sharp stick in the eye - or in the wallet.

Unfortunately, Genta announced during the position that its experimental drug (Genasense) only extended the life of cancer patients in a clinical trial by an average of 1.2 months. While Genta claims the benefits are much better than the longevity data indicate, Wall Street saw it differently. Genta dropped below $15 on Sept. 3rd, recovered, then had a bad day on Sept. 9th and dropped harder on Sept. 10th and fought for the next few days to hold price. GNTA steadlily dropped below $15, going as low as $13.76 on Monday. On one dip we got out of the call by repurchasing it for an average of $0.2423. The reason for buying back the call was to free up the GNTA stock (you can't sell stock that is covering a call option) so that it could be sold at a higher price without the call premium rising along with it and blotting up the price appreciation. That is, if GNTA had gone back up to, say, $14.50 the Sept. 15 call probably would have gone up with it almost penny for penny, like a call in the money.

The GNTA Sept. 15 call held its price all during its drop below $15... it wasn't giving up much of its price as it fell. Put differently, the market makers were making sure it cost too much to exit with a decent profit. Why didn't we sell out the position at $15 or even $14.50? After all, we would have gotten much more for the stock. True, but we would have paid a lot more to buy back the Sept. 20 call. For example,when GNTA was $14.50, the call would have cost $0.65 or $0.70 to buy back. The GNTA call just didn't lose much value as the stock fell. Besides, with a $13.60 breakeven you shouldn't panic and close the position at $14.50 or $15, although you might close it if the 15 call had gotten really cheap to repurchase - but it didn't. So we elected to close the option leg (the option portion) of the trade as cheaply as possible, in order to free us up to sell GNTA when the price rocked higher.

Except, hmmm, it didn't go higher. It very briefly traded at $14.21 on Monday, but not in sufficient volume or for long enough to get out at that level. We could have waited until Tuesday in hopes that GNTA's price would recover, but we decided the better part of valor was to get out of a threatening trade. Hindsight is always 20/20, but not helpful in the least, and GNTA is a prime example. Today (Wednesday) GNTA has hit a high of $14.90, but there was no way at the decisional point to know the price would recover, especially since a minor support level at $14.50 had been breached. Even more worrisome, GNTA frequently had been opening significantly down from the prior day's close since the bad news came out. So getting out of the trade on Monday was the smart call to make at the time.

And herein is a powerful lesson: you can't trade on hindsight...

The essence of good trading is to make the right decision at the time. Nothing is more common in trading than to make a hard decision to exit a trade only to watch the stock recover. The problem obviously is that many times they don't recover. Making the hard decisions are a crucial part of money management and trade discipline. Had we held GNTA in hopes of a price recovery and gotten another price fade, how would we have justified our action? The answer is that we couldn't have... holding it would have been either betting on the support level or at worst, simply hoping for the best - - things we don't do. If you consistently hold onto trades when they go wrong, hoping for a recovery, you are gambling... and you will lose far more often than you win.

Support.  To be sure, GNTA had some support in the $14.50 range, which was a prior resistance level overcome, and more recent support in the $12.00 - $12.50 range. It was a somewhat safe bet - though no sure thing - that it would hit the $12-12.50 level and recover. But at the level we closed the GNTA position, GNTA had already fallen below the $14.50 support and was touching the 50-day moving average (MA) on a daily chart, and on a 60-minute chart had already broken far below the 50-MA and was at the 200-MA, which are not reassuring signs. Trading our own money, we would have been tempted to bet on support holding and a price recovery back well into the $14 or $15 range - which has now happened. GNTA found support at the $13.85 level, it has held the 50-MA and seems to have recovered. But you can't know that in advance.

The Roll. We considered an attempt to buy back the Sept. 15 call and sell the Oct. 12.50 call, which was paying $2.10 at one point on Mondaycfdx. This action (known as rolling down and out, since you sell a call that is a further expiration month out and that has a lower strike price) would have yielded a net return on the entire trade of 4.5% for nearly two months of holding time, so a return of roughly 2.25% per month, assuming no further hard drops for GNTA. Not too exciting. The problem, however, is that there was hardly any volume in the GNTA Oct. 12.50, thus no way to sell the number of contracts that would have been necessary.

This brings up a good point: why didn't we write the Sept. 12.50 call in the first place, instead of the Sept. 15? The answer is that the return on it was much lower than the 15 call, and we figured that $3 in premium would be enough protection. However, GNTA dropped too far and the 15 call held too much value even into expiration week. But trading is a series of calculated risks. If you always pick the very most conservative strategy you will win more often, but not make as much money as a less conservative trader who maximizes premium return and looks for smart support levels.

Trade lessons? There are several here for you, and we learn something as well from every trade.

First, GNTA was at the top of our $15 and Up, Deep-in-the-Money and Deep-out-of-the-Money lists, so it was volatile. Stocks with high covered call returns have those high returns for a reason - always keep that in mind. The safer plays pay a half or third as much, but can be much safer. It is hard, though, to get 5% a month with hammer-safe trades. But we are fairly cautious, and we liked GNTA enough to do the trade.

Second, our breakeven point in GNTA (stock cost less premium received) was slightly below a support level at $14 but well above the more recent $12-12.50 support level. While some traders differ on this point, we think that you ideally want a breakeven point at or below support. Why? It is very comforting to us to have the support level below the breakeven point (which really is your decisional point for exiting the trade), so you know whether the stock has held support or not by the time the price gets close to breakeven. That is, if it hasn't held support, you get out fast. Also, stocks more often than not will hold support (that's why the concept of support levels exists in the first place), so a breakeven below support gives the stock a chance for support to hold and the price to recover. A breakeven above support means that you have to make the decision to get out before knowing if support will hold. You can't always manage to write a breakeven below support, but month in and month out your trading will do better if you can. And GNTA is a prime example of how even a huge call premium does not guarantee safety. We ultimately chose not to take the chance on the stock falling to the lower support level.

Third, when in doubt about a stock, either leave it alone or write a deep-in-the-money call. Novice traders might wonder how GNTA could drop $2.60 and not hand them a loss. That is a big drop! The reason simply is that the $3 premium received cushioned the fall and lowered the breakeven point to $13.60. That is the magic of DITM calls and puts.

If you like a stock carrying a high premium, but worry about a price drop, then the safer strategy is to write DITM to get the cushion. The only problem with DITM calls is that the premium evaporates seriously a couple of weeks before expiration. This means you should write it with 3 or 4 weeks remaining until expiration. But a shorter trade is fine if the premium makes it worth the risk; only you can decide.

Here's an example: if a stock is $18 and volatile, you might consider writing the $15 call for protection. A month out from expiration that call might pay $4.50, a nice $1.50 return (you can't count the $3 of intrinsic value received). But three weeks later with a week remaining to expiration the stock still is about $18 and the 15 call is now going for $3.40, a $0.40 return. What changed? It lost time value, that's all. But the risk of the stock may still be just as high as it was earlier (if the volatility event causing the high premium has not yet resolved itself), except you got $1.10 less in premium. Sure, you'll only be in the trade for a week instead of a month so the return is good, but risk is risk, and your cushion is not as good at $3.40 as with $4.50. Some traders would disagree, but $1.10 can make the difference between a nice, fat trade and a loser.

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