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Covered-Calls 101

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Technical Analysis - Identifying Bearish Stocks

Considering the recent retreat in equity values, it seems like a good time to review the common (technical) stages of a stock with a focus on lateral and bearish trends. For those of you unfamiliar with this approach to technical analysis, it is one of the most successful methods of charting and 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 his 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 a previous segment we discussed stage one (I), commonly known as the basing stage and stage two (II), which begins with the transition to a bullish cycle and often results in a sustained uptrend. Today's narrative offers a brief description of stages three (III) and four (IV), including some hints for timing exit and adjustment transactions. First on the agenda is stage three, which is depicted as a "topping" or consolidation phase.

Stage Three (III)

Normally, stage III 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 II before closing the position.

Obviously, this is not a "perfect" stage III 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 (IV)

Stage IV; 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 IV, 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 III (lateral activity) to stage IV (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 I (basing stage) however once the selling subsides, the cycle will begin all over again.

Diversity and Timely Portfolio Management are Prerequisites to Success

When the chart of a stock in your portfolio begins to resemble the above example, it's definitely time to take action. Remember, success with this type strategy lies in one objective; a consistent flow of monthly income with limited portfolio risk. The focus of position selection and management should be to continually generate an acceptable level of option premium while protecting against the potential for downside losses. Positions that become unfavorable due to changes in the fundamental or technical characteristics of the underlying issue must be removed from the portfolio before they can generate large deficits. While each individual situation will require a slightly different solution, we try to limit individual position losses to 20% of the initial investment. For inexperienced traders, the hardest lesson comes when you close a losing play. It is very difficult to learn to exit unsuccessful trades in a timely manner but the simple fact is, there is no reason to hold a losing play when there are so many other profitable positions that deserve your time and money. Accept your losses; learn from your mistakes and evaluate each one critically; and move on!

While even the most catastrophic events can generally be managed to reduce the effects of the shortfall, there are occasions when issues plunge without warning, leaving no opportunity for exit or adjustment. Unexpected events simply occur; earnings warnings, shareholder lawsuits, negative news in the industry or sector and changes in public sentiment. All of these activities can affect the success of an individual position but with a well diversified portfolio, the long-term effects are minimal. Experienced traders know that losses are inevitable with any strategy. Instead of being surprised, they anticipate them. Statistics dictate that a percentage of the positions you select will be unprofitable thus, when the situation arises, it should not be regarded as a failure but rather an integral part of investing activity. In all cases, your portfolio should be evaluated based on the sum of its positions rather than each specific transaction. In this manner, success is gauged by growth in portfolio value and individual losses become less significant. That is the primary reason for maintaining a balanced portfolio with several positions; it becomes easier to identify and act on a potentially negative play when it doesn't have a significant effect on your overall success.

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