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Covered-Calls 101

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Technical Analysis - Stock Stages (Part II)

Considering the recent retreat in equity values, it seems like a good time to continue our review of stock stages with a focus on lateral and bearish trends. As noted last week, one of the most successful methods of charting or technical analysis is described in the book "How to Profit in Bull and Bear Markets", by Stan Weinstein. Stan has been called one of the world's greatest technicians and in this renowned publication, he provides a detailed explanation of how to evaluate the condition and outlook for stocks in terms of stages. The book is available in the Option Investor bookstore.

In the previous segment we discussed stage one, commonly known as the basing stage and stage two, which begins with the transition to a bullish cycle and often results in a sustained uptrend. Today, we carry on with a brief description of stages three and four, including some hints for timing exit and adjustment transactions. First, we'll look at a stage three, which is depicted as a "topping" or consolidation phase.

Stage Three

Normally, stage three is the period when the stock begins to encounter technical weakness (from a decline in buying pressure) and fails to make new highs. It is often identified by the issue's transition to a sideways or lateral trend and a crisscrossing of the moving averages. For short-term traders, this is the best time to tighten stop-loss orders and take profits if the rally continues to fade. Of course, covered-call writers generally have an additional measure of downside protection and can allow the stock more leeway to resume stage two before closing the position.

Obviously, this is not a "perfect" stage three chart, but it's fairly close. The first sharp decline (to the $75 range) probably shook out many long-term shareholders and the issue eventually began to trade below its 30-week MA (the 50-week MA is off the bottom of the chart) for extended periods. Technically, a support area has been established near $80 but a break below that range would signal a move towards stage four. On the other hand, a lateral trading pattern after an extended rally can last a long time and the uptrend will occasionally resume after a lengthy period of base-building. Remember, technical analysis is not an exact science and this is a good example because stage three formations can exist for several years before the issue returns to a directional trend.

Stage Four

Stage four; the declining phase, occurs when the previous lateral trend breaks down completely with the stock falling through a long-term moving average and then failing to rebound above it. The moving average eventually turns downward as the stock continues to decline and achieve new lows. When a stock enters stage four, it's generally a good time for covered-call writers to close their positions and move on to more profitable plays. For those traders who favor bearish strategies, it is important to verify the issue has room to fall further before shorting the stock or buying puts. Also, be sure to identify any near-term support areas and place protective trading stops and buy-to-close orders accordingly.

This chart provides an excellent example of how abruptly the trend can change from stage three (lateral activity) to stage four (bearish decline) in a relatively stable stock. The "key" signal for this transition occurs in conjunction with a broad sell-off in equities and the resultant move below a multi-year support level (near $30) is simply too much for the stock to overcome. All of the subsequent "recovery" rallies fail to inspire any sustained buying pressure in the issue, thus the downtrend continues and eventually lasts for almost two years. Only near the end of the chart does the issue show a few early signs of stage one (basing stage) however once the selling subsides, the cycle will begin all over again.

Trade Wisely!

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