Option Investor

Covered-Calls 101

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Chart Analysis & Entry Timing

New subscribers often ask about the most important things to look for during the screening process for covered-call candidates. Obviously, there is no form of analysis that will guarantee success in the stock market but having a basic understanding of the different phases of stock price activity can help a person trade with greater confidence and it can also make tasks such as position selection and portfolio management much easier.

The stages of a stock's (price) cycle are described at length in "Secrets for Profiting in Bull and Bear Markets," by Stan Weinstein. Without going into great detail, the key premise of Stan's theory is that every stock or index sequentially moves through four stages:

1. Basing
2. Advancing
3. Topping
4. Declining

Stan's research also suggests that this cycle is repeated over and over again, thus by analyzing a stock with regard to these phases, an investor can project its future trend (or lack of it) with reasonable accuracy.

Stage Analysis

The first two stages of a stock's price cycle offer the best entry opportunities for covered-call writers. A trader who can identify these patterns will be better prepared to select favorable candidates and initiate the positions in a timely manner. Here are descriptions and examples of each stage:

Stage one is a "basing" stage that can last for months or sometimes years. The condition is usually defined by little or no vertical activity with a long-term moving average that is basically flat. A common axiom suggests that, "the longer the base, the stronger the case" and issues with this type of pattern generally have low capital risk as there is little downside potential from the current price range.

Stage two is when the issue begins to exhibit signs of a new upward trend. The stock price closes above a long-term moving average (150-200 dma) with the average turning up, and this is one of the ideal times to enter a bullish play. Investors should look for the next resistance level to identify the potential profit target or range of movement. Short-term traders should focus on stocks that have "room to run," picking only those issues that are in stage two cycles and buying on pullbacks to technical support; trend-lines, moving averages, previous resistance, etc.

Here are some hints...

A. The beginning of stage two is the "ideal" time to initiate a bullish play. For trend trading, pick stocks that are advancing in a stage two rally and buy on the pullbacks to technical support such as the major trend-lines.

B. Watch for volume - this is vital! Most "big movers" climb on substantially larger volume than that which occurs at any time during the basing stage.

C. Look for strong relative strength. When a stock breaks out of a basing pattern, the relative strength indicator should cross up above the zero line into positive territory. The higher the climb to cross above the zero line, the more upside potential in the movement.

D. Look for the "Runner's Crouch" pattern before the stock breaks out of a long-term base. In many cases, stocks will go through a short period of building strength for the upward move. It's usually a small dip to gather momentum for the bullish surge above the moving average. Once the stock crosses above the top of the base (resistance) it should also continue through the moving average.

E. After the rally begins in earnest, the long-term moving average should start to turn upward and when the stock eventually corrects back to a technical support area, the next run-up, if supported by heavier-than-average volume, will likely continue until a new (near-term) high is achieved.

Regardless of the type of analysis you favor, it is important for all market participants to become familiar with the common methods used to forecast the movement of stocks and indices. This knowledge can then be applied as a practical element of the selection process for a number of equity-based strategies, including covered-calls. Once you are comfortable with the popular indicators and timing signals, you can combine them with your personal techniques to develop a system that yields profitable trades on a regular basis.

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