For the covered call writer, stock price and support levels go together like ham and eggs and are in fact inseparable for achieving consistent trading returns. Put differently, stock price and call premium are meaningless if not viewed in conjunction with support levels. We have noticed over the years that one of the most common mistakes call writers make is to write focused only on premium or stock price without taking the support levels into account. This is especially dangerous where the stock price has spiked and not yet settled back.

Stock prices will spike from time to time. The spike may come in the form of a single, wide-ranging day, or several strong up days (white candle days) in a row. In either case, the spike in price often causes nearby support levels to be left far behind. The question is: can such stocks be safely written as covered calls and how?

The chart-related elements of analyzing a potential covered call trade are well understood:

stock price
call premium
call strike price
support level
chart strength

In this article we will not discuss trendlines, moving averages or other indicators of chart strength, since we cover those topics in detail elsewhere in our free Trade Coach series for CallWriter members. We've made the point over the years that no single element above determines the desirability of a trade. They all work together and must be viewed together in analyzing a potential trade. Potential trades present a real issue where there has been a recent price spike well above support levels that has not yet pulled back. We're not saying that strong price advances are bad or dangerous in and of themselves, only that they present dangers where the price has outrun support.

Example: Let's assume that a hypothetical stock (BUMM) has recently run from $30 to $35, and the front month 35 call can be sold for $2.00, a 5.7% return for a hold of less than 30 days. On its face, this is an excellent return. But this stock has moved up strongly and could pull back. Suppose there is strong support at $33.50 in the form of a former resistance level now converted to a support level? This bodes well for the trade, since there is support above the $33 breakeven point. But what If the closest support level is at $30? If the stock falls back there would be no support between $35 and $30, and if it does pull all the way back that $2.00 premium won't look so good, will it? Suppose the support level is even further down, at $28? There would be a clear risk of $7.00 ($35 - $28) but the trade yields only $2.00 in premium! Only an inexperienced call writer would write the 35 call with the stock at $35 and support $4 to $7 below the current price.

This brings up an important rule of covered call trading: the premium has to be related to the risk in the trade. Consistently violating this rule will pick your pocket steadily except in the strongest market, and it frequently will get picked even then. The following charts illustrate the dynamics of writing spikes.

Andrew Corporation (ANDW)

In the following daily chart, ANDW has spiked up in two days from $12.11 to almost $14. This is not a huge price advance in dollar terms but is significant as a percentage of price. First notice that the price is hitting resistance on this spike and is highly likely to fall back. Next, notice the support levels. There are three support levels, one at $12.20, one at $10.83 and one at $9.95. Assume that the 12.50 covered call was written for a $1.25 premium when the stock was at 13.50. This would protect the writer down to $12.25, only slightly above the highest support level. But suppose the 15 call was written for a $0.25 premium? The resulting $13.25 breakeven point leaves too much risk, because the breakeven is over a dollar above the closest support level.

Rambus, Inc. (RMBS)

The following chart poses even more dramatic dangers from spike days. Note the October spike that took price from $19.20 to $29.55 in two days, a rise of more than 50%. Yet the highest support level, which is a former resistance level, is $21. Spikes like this almost always pull back, though they rarely give up all of the advance. How could RMBS be safely written at the higher end of the price spike? The answer is that only an ITM call could have been written without putting the writer at grave risk from a pullback. And in fact the stock did pull back almost immediately, declining to $23.57 by October 27th, which gave back most of the spike. RMBS has recently been a very spike-y stock. Note the most recent spike, which is still several dollars above the most recent support level of $32.47.

What would have happened to a trader who wrote the 30 call on RMBS's October spike at $28 or $29? He or she probably would have been hurt badly, because the small OTM premium would have been no protection against the pullback that occurred. What if the ITM 27.50 call had been written when the stock was at $28 or 29? The writer also would have taken a hit, almost certainly, for writing too far above support, though not nearly as large, since the larger ITM premium would have offset much of the pullback. The canny writer, who wrote the 25 call when RMBS was at $28 or $29, would have been in good shape, however, because he would have gotten a premium that was at least $3.00 to $4.00 of intrinsic value plus time value.

Trade Tip: Since pullbacks rarely give back the entire spike, it is not necessary to write covered calls on a spike with the breakeven right at support. But the farther above support you write, the more uncertainty - and risk - is introduced into the trade.

Obviously, the larger and stronger the company, the less is the likelihood of retracing all or most of the spike; and vice-versa. Some stocks very rarely spike, and some do it relatively often. If the stock is given to making spikes and sharp drops and tends to give up all or most of the spikes, then it should be avoided for covered calls entirely. We tend to avoid stocks that have spiked for no discernible reason. If there are no press releases or news items driving a spike, the only explanation for the spike is inside information (unknown, dangerous territory) or good old-fashioned market manipulation (you were not invited to the party, so stay away).

Determining support levels always is critical for the covered call writer, but they are absolutely essential - life and death - when writing stocks that have recently spiked up and have not yet settled into a new trading range or trend. If the pullback already has occurred and a new support level established, then you trade based on that.

But where the pullback has not yet occurred, the dynamic is pretty simple: if the support level is far below current price, the premium has to be bigger. If the premium is small, there had better be a support level close by. Price has a way of finding the nearest support level. What hurts the trader isn't the spike, nor even the inevitable pullback, but the gap between current price and support. Sometimes in strong price action the stock doesn't pull back much, but don't count on that. Count on support.

How to Write Calls During Spikes?

It is possible to write stocks that are spiking or advancing hard. Traders just have to be careful and exercise what really is just common sense. Here are some hard-learned guidelines for trading that we have developed over the years. It is easier to understand the reasoning if you view the trades in terms of whether the call is at the money (ATM), in the money (ITM) or out of the money (OTM).

The above reasoning applies in all trades, really, not just spike situations. The best example would be a stock that has not spiked but is making a new high in a strong uptrend and has not pulled back in some time. The exact same concerns are presented, and the exact same analysis applies. In fact, using the above guidelines in all covered call trades is beneficial, because traders should never get into a trade without knowing precisely where support is and whether the call premium is adequate in light of the price/support gap.

Obviously, some chart reading experience and training are invaluable in trading spikes. This is why CallWriter has developed its renowned (and free) Trade Coach series to teach covered call writers the basics of writing covered calls and of charting. Applying these common sense rules will open up a world of trades that might otherwise appear too dangerous or daunting to attempt.

Ways to Try CallWriter Try CallWriter for 10 days without risk - absolutely free! You'll have full access to our membership site! A $27.00 value Details Buy one month of CallWriter membership and get the second month free! $79.95 Save $79.95 Details Buy John's Ultimate Covered Call Book now and get two full months of CallWriter membership. $139.95 Save $119.90 Details Contribute an Article To contribute an article to the Money NewsLetter, send your contribution, along with your promotional byline, to: newsletter@callwriter.com. We don't pay contributors, but we will include your byline and a link to your website. Reproduction Don't hesitate to print out this newsletter for your own use or forward a copy of it to your friends and associates (we want you to), but please ask permission before reproducing the content in any form -- we would like to know who you are and how you are using it. Disclaimer We are not brokers, investment advisers or securities analysts and do not recommend the purchase, sale or holding of any security. Your use of any information or strategy appearing in this newsletter or on CallWriter.com is solely at your own risk. We urge our newsletter subscribers and CallWriter.com website members to do all requisite and analysis and properly plan each trade prior to making the trade and to manage each trade effectively. Covered call and other potential trades discussed in this newsletter or on CallWriter.com do not constitute trading recommendations by CallWriter or any other person and are presented by solely for informational and educational purposes.