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Covered-Calls 101

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Stock Selection: Identifying Common Chart Patterns

In the previous segment, we talked about target-shooting a specific cost basis with the buy-write order. Indeed, the buy-write is a great method for initiating a covered-call, however the strategy is useless if you can not identify an acceptable price or cost basis for the position. The first step in this process involves analyzing the technical condition of the underlying issue. Professional traders generally focus on the primary trend and character of a stock during the preliminary screening. Once they have established a list of favorable candidates, the search is refined to identify stocks with proven chart patterns and well-known technical formations. The objective is to find indicators that point toward key (price) levels where market catalysts such as buying support or overhead supply are likely to affect the future value of the issue.

While there is no "best" approach to technical analysis, many traders believe the most profitable indicators are specific chart formations that routinely precede certain price movements. A large portion of these formations fall into the category of area patterns and the associated trends have proven time and again to have predictive value. With that fact in mind, it's important to be familiar with some of the bullish patterns you may see as you analyze stocks for covered-call positions.

Ascending Triangle:

Right-angle triangles are the most popular group of area patterns. These patterns are easily identified; one of the two trend lines is generally flat while the other points toward it. When the top trend line is horizontal and the lower trend line slants up and to the right, meeting the upper line at an intersection beyond the price, the triangle is ascending. The outlook for this type of formation is bullish and the continuation rally (after a break-out has occurred), is generally of the same magnitude as the height of the original triangle.


Pennants and Flags:

In a flag pattern, the upper and lower boundary lines pattern are generally parallel though both may slant up, down or sideways in the trend. In a bullish trend, the formation resembles a flag flying from a mast. This pattern tends to form during the middle of a rally. A pennant is similar to a flag. The major difference is a pennant has converging rather than parallel trend lines (much like an ascending triangle). It generally occurs in a period of congestion. The pattern is short-term and forms after a sharp upward movement in price.


Rounded-Bottom:

The rounded bottom is a reversal pattern that reflects a gradual and symmetrical change in trend from bearish to bullish. The price pattern (and often the volume pattern) will resemble a concave shape similar to a bowl or saucer. It can be either long-term or short-term. A series of rounding bottom formations can occur where the rising end moves higher than the preceding top of the previous pattern. Individual formations are generally 1 to 2 months long and the change in price can be up to 25% of the share value. Here is an example of a long-term saucer:


Head-And-Shoulders Bottom:

This formation is one of the most common reversal patterns. The first element is a pronounced sell-off in which volume increases during the decline. A brief recovery follows but the rally fails near the support area of the previous range (prior to the initial break-down). Now the left shoulder and neckline are established. A second sell-off drives the stock price to new lows but volume quickly fades and a decisive reversal begins. The lowest price is the (inverted) head of the pattern. The recovery again fails at the neckline and with traders unwilling to commit fully to the new trend, the stock fades to a short-term low; approximately equal to the left shoulder. The slump is brief and the change in direction is once again decisive (often a hammer-bottom). The new rally is supported by a surge in volume and the momentum carries the issue up and through the neckline (previous resistance) of the pattern. At this point, a successful test of the neckline (now support) is the final confirmation of a new trend.

As with most forms of technical analysis, the main premise is that past price behavior can be used to forecast future trends. But, as with any system, chart patterns should always be viewed with regard to other indications from the instrument being evaluated. With trial and review, you will discover which patterns work best for your style of trading and the market in which you participate.

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