Option Investor

Covered-Calls 101

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Position Selection: Choosing the "Right" Stock

There are two common methods investors use to forecast the price of financial instruments: fundamental and technical analysis. By and large, older investors are more comfortable with fundamental analysis. In this process, one attempts to predict the future value of a company's common stock by evaluating the earnings, market share, product revenues, pricing structure, and operating margins, as well as various other fiscal components of the underlying business. In contrast, technical analysis has nothing at all to do with the profitability or economic worth of company; it involves the study of historical prices, directional trends and chart patterns. While fundamental analysis is founded in large part on projected or pro-forma data, technical analysts try to establish the potential direction and magnitude of a stock's movement based on its past activity. Of course, each style is often viewed as less than adequate by the opposing group, yet there is value in both methods and in many cases, either approach can produce favorable results.

From a practical standpoint, technical analysis is more suitable to short-term trading, since it offers the most accurate method for identifying entry and exit points. At the same time, fundamental analysis can often provide a more accurate picture of the long-range outlook, yet it is miserably inefficient for predicting the near-term movement of stock prices. Nevertheless, analyzing the value of a company can help to forecast future profits (or losses) and since earnings significantly affect share values, it is important to have complete and accurate knowledge of a company's financial condition. We have all witnessed how a quarterly report can affect the short-term trading activity of a stock and the catastrophic losses that can occur when a company announces earnings that are different from the current consensus estimates. A worse-than-expected profit outlook will also cause stock prices to fall and when the news becomes public, analysts are quick to change their opinions on the company, downgrading the issue and causing further damage to its share value. Obviously, this is one of the few times when fundamental analysis might be helpful in a short-term trading scenario.

Although some extreme fundamentalists dismiss technical analysis as investment voodoo, simple charting techniques are proven tools that stand up to the test of time. A price chart does nothing more than reveal buying and selling patterns that would be almost impossible to discern by reading daily quotes in the newspaper. Charting clearly reflects the repeated accumulation that occurs at periodic lows and the climax selling (or distribution) that develops whenever a stock reaches a historic top. Various systems have been developed to help investors form an opinion about future tendencies (and likely catalysts) based on the past price activity of the underlying issue. Most analysis begins by determining the strength and direction of the primary trend and the foundation for additional forecast is predicated on the premise that once a trend is in motion, it will continue in that direction until a change in character occurs.

Which Approach is Best?

Using the covered-write strategy as an example of the differences between the two types of analysis, a conservative investor who utilizes trend and/or sentiment indicators might sell short-term, in-the-money options on technically favorable companies to achieve small gains. In contrast, an investor that focuses on fundamental or valuation analysis to make portfolio decisions would likely buy shares of historically profitable companies and write out-of-the-money options with two or three months of time value to reduce the overall cost basis of his position. Since most of the candidates offered in the Covered-Calls System are of a short-term nature, we favor technical analysis as the primary means for stock selection. Our research bases its forecasts primarily on past prices and their indications with regard to directional trends, moving averages, and support/resistance levels. Trading volume and momentum indicators are also primary considerations in our initial screening procedure. All of these components are invaluable in the stock selection process and although we understand the need for fundamental valuation, we believe it is more important to focus on the current technical character of the market, industry groups, and individual issues.

Those who are relatively new to technical analysis may think it is too difficult to learn, however the key concepts are really very easy to understand. In fact, this seemingly complex approach to stock valuation is founded on three simple assumptions.

1) The current market price of particular security or financial instrument is the true value of that issue at any given point in time

2) A thorough study of market-related data such as price, volume, and buying pressure (accumulation/distribution) will uncover identifiable trends or patterns in any issue

3) History eventually repeats itself

These assumptions can be combined with the study of historical data to provide investors the information they need to formulate profitable trading strategies because the technical indicators that lead to buy or sell signals are contained in various chart formations and patterns. The most common of these chart patterns or indicators are the "trend" and "trading range." Trends are generally categorized as up, down, or lateral while trading ranges are typically defined by support and resistance levels. It is important for an investor to be able to identify these trends or trading ranges and recognize the historical chart patterns that signal major turning points or reversals.

Trends & Trading Ranges

The first step in pattern analysis is to draw the trend lines. Since two points define a line, the basic requirement for all trend lines is that there be at least two points connected. However, most analysts require a minimum of three points to confirm and justify the trend. After the trend line is established, its character can be determined. Uptrends are evidenced by a series of trading sessions with successively higher highs and higher lows while downtrends are just the opposite; a series of trading sessions which exhibit lower highs and lower lows. For most traders, trend lines are the primary category of technical indicator used to identify buy and sell signals.

Another general classification of price patterns is the trading range. A trading range occurs when the price of the instrument remains between a clearly established high and low value. The upper boundary is known as resistance while the lower is termed support. A resistance level is established when there are more investors willing to sell, rather than buy, at a given price because they believe the security is overvalued at that level. A support level will occur when investors feel the stock is cheap or undervalued at a given price and they can't afford not to own it. From a chartist's point of view, that is the area where it is most advantageous to initiate new positions.

Trading ranges can also occur as part of an uptrend or downtrend. These patterns are often called "continuations" since the general direction of the overall trend is not changed. Another type of buying signal can occur in the transition or "reversal" from an uptrend to a downtrend. A key reversal occurs when the daily price range has a high that is above the previous day's high and a low that is below the previous day's low. It is often referred to as an "outside trading-range" day and most analysts agree that this short-term pattern (a close above previous day's final price) is a bullish signal. If the key reversal occurs near a bottom in the long-term price cycle, a trend reversal is likely in progress and the opportunity can be used to initiate long stock positions with relatively low downside risk.

In all cases, the goal of the technical analyst is to use the past price activity, trends, and chart patterns of a particular stock to predict its future direction and possible changes in character. Once you can do this accurately, on a regular basis, you are well on your way to becoming a successful options trader.

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