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January 15, 2004
Writing Price Spikes
By John Brasher, CallWriter Publisher
| One of
the more dangerous times to write a covered call is when the
price has recently spiked, because what goes up might come
down. The market has a penchant for taking away price advances
that come too fast, or too easy. If you ignore price spikes
or write without a decent support level, then sooner or later
trouble will (as the bluesmen say) come to stay at yo' house. |
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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.
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.
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.
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).
OTM
Calls |
We don't like
writing OTM calls on hard advancing stocks except in a strongly
up market. Even then, there is a significant difference between
a stock in a strong uptrend and one that has recently spiked
up in price, so make sure you know the difference. The OTM call
offers the least protection of all from a pullback, so write
OTM only if there is a support level very close to or
above the trade's breakeven point. Otherwise the losses
you will take from writing too far above support will outweigh
the returns from the few winners that finish in the money and
get called out for higher return |
ATM Calls |
While ATM calls indisputably
pay the highest returns month in and month out, they don't provide
the most downside protection. Write ATM calls on price spikes
only if there is a support level reasonably close to
the trade's breakeven point. If the stock consistently
has high-yielding call premiums (frequently appears on the CallWriter
Real Time Lists™) and is a solid company, such
as Oracle or NSM, you can take more of a chance, since there
is a much better likelihood of writing your way out of a loss
if the stock drops. But if the stock is a small one or new to
the high-returning covered call club, cut it no slack whatsoever.
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ITM Calls |
The ITM calls, which generally
provide the lowest returns of all calls, also provide the
most protection in the event of a pullback. In the BUMM example
above, it might make more sense to write an ITM call on the
stock for a smaller return, since the higher premium would
provide far more protection. ITM calls can be written on price
spikes if there is a support level reasonably close
to the trade's breakeven point or the likely retracement point.
For example, if the 30 Call were written on
BUMM at $35 for a $6.25 premium, the actual return would be
only $1.25 (3.5%). But the all-important fact is that the
writer would be getting a cash premium of $6.25, which protects
down to $28.75. |
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.
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