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More on Entry Points - The Covered Call

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By Mark Phillips

As the month of August meanders along, it is becoming increasingly clear that we are in an ever-tightening rangebound market. Either we will continue along the current sleep-inducing course, or we will break out of the pattern. Profound, huh? If I were an analyst for Merrill Lynch or Prudential, that insightful statement would earn me a fat 6 or 7-figure salary. In all seriousness, the rangebound market has to break eventually -- the question that is on all of our minds is WHEN?

If we knew that, we could move our investments into cash, take a relaxing vacation until just before the glorious day arrived, return and make a killing. Hmmmm...have you noticed the anemic trading volume lately? Maybe that is precisely what the pros have done this month...just a thought. But as long as this rangebound market endures, conservative strategies like writing covered calls are likely to shine for us. But when the market or stock we are following trade in such a narrow range, entry points must be precise and well-considered.

To that end, we spent our time together last week detailing the ingredients necessary for opening the long leg of our LEAPS covered call position. Using the recent LEAPS Portfolio entries in Cisco Systems (NASDAQ:CSCO) and Sun Microsystems (NASDAQ:SUNW) as examples, I think we built a model of how we can play even beaten down Technology stocks profitably. In a nutshell, we wait for weekly and daily Stochastics to bottom in oversold and for the daily Stochastics to emerge from oversold as the stock bounces from major support. Sounds simple, huh?

Actually it is, as we showed last week, but it requires patience, a quality in short supply (at least in my house) as we wait for our entry parameters to be satisfied. If you missed last week's article, I would recommend taking a look before proceeding with the remainder of tonight's article. It can be accessed from the following link: More on Entry Points

Proving its utility, the daily Stochastics gave us solid long-term entries on both CSCO and SUNW, letting us into the plays at $16 and $14, respectively. Then all we needed to do was wait for the daily Stochastics to rollover from overbought territory, accompanied by price weakness. With plenty of time available in our 2004 LEAPS, we are in no hurry to initiate the sale of the near-term calls and can wait for conditions to be right.

We got a decent opportunity on CSCO last Monday as the daily Stochastics rolled down out of overbought territory, but a look at the big picture would have kept me on the sidelines for a wee bit longer. Although the price was showing some weakness, I had my eye on the company's earnings report set for yesterday. I was looking for one more push higher before the much-awaited announcement and was rewarded 3 days later on August 2nd. The price spiked through $20.50 before the sellers emerged and they stepped up their efforts earlier this week ahead of the company's earnings report. That gave us an aggressive entry (labeled:A) on the daily chart, and shown with multiple possible entries on the hourly chart.

The high odds (read:conservative) entry would have been to wait for the rollover to commence before selling our calls and that event occurred this Monday as the price dropped back under $20. By that time, we could see declining peaks on the hourly stochastic, confirmed by the daily stochastic dropping out of overbought territory.

So now that we are ready to sell those calls, the big question is "which ones to sell?". AUG or SEPT? $20 or $22.50? While there is obviously more premium available in the $20 strike, we need to keep in mind that we don't want to have to worry constantly about whether our sold call is going to expire in the money. That is enough to push me out to the $22.50 strike, as it appears highly unlikely (especially so, now that we have seen the market's reaction to the company's earnings report) that CSCO will move above that level in the near future. But looking at the current quotes (as of Monday), there just isn't premium in the AUG contract as there is less than 2 weeks until expiration. So by default, we find ourselves pushed into using the SEP-22.50 Call. Checking the quotes, we find that we can sell the calls for $0.65. Not a fortune, but it is more than 10% of what we paid for the 2004 LEAP and the first step on our long path to getting those CSCO LEAPS for free.

In hindsight, we can see that we would have done much better selling the AUG-20 calls, but that was a more aggressive posture than we are currently targeting in our discussion here. In the end, strike selection comes down to a matter of personal preference. Since we are covering the details of entry points, let's move on to our next example and see what other lessons we can learn.

SUNW also gave us a great long-term entry, when it fell to and bounced from the $14 level a couple weeks ago. This popular Tech stock helped to lead the NASDAQ on its recent assault on the 2100 level, and gave us a couple chances to sell covered calls this week as well. Note that the one-day dip last Monday wasn't severe enough to drag the daily Stochastics out of overbought territory, thus preventing us from taking a premature entry. But since then, the picture has improved significantly for call-sellers, giving us an aggressive entry last Thursday/Friday. A more conservative opportunity materialized today as the NASDAQ rebound fell apart and SUNW rolled over once again.

After pushing through the $17.50 resistance level last Thursday, bulls starting hoping for the NASDAQ to continue its rebound through 2100. Aggressive traders could have sold calls on that late-day spike (circled on the hourly chart), but the conservative approach would have been to wait and see whether the stock was able to power through the next level of resistance at $18.25. Prices fell back at the open on Friday, but those aggressive traders had to sweat a little bit as the stock consolidated above the $17.50 level.

This week has seen several attractive entry points, with the pullbacks from the $17.50 level early on Monday and Tuesday and the rollover today from just below $18. With the daily Stochastics in full roll now, we could have used any of the hourly stochastic rollovers as an opportunity to sell our calls. Obviously, today's rollover provided the best balance of risk and reward...isn't hindsight great? More than likely, I would have been in the play on Tuesday's morning rollover, so would have had to endure a bit of nervousness as prices surged ahead of CSCO's earnings report last night.

Again, we have to go through the strike selection process and have almost the same limitations faced in the CSCO trade - namely August strikes have too little time premium to allow us to collect any meaningful premium without selling a strike that would be in danger of expiring in the money. But let's approach this one from the more aggressive perspective for educational purposes. Since time is on our side with only 2 weeks until expiration, let's target a near-the-money strike in August. Checking our quote service, we find we can sell the selected option for $0.60 as well, taking the first step towards financing that LEAP we bought a couple short weeks ago.

While there are quite possibly better plays out there and many of you might have eked out a better entry than the potential ones I have outlined here, I think it should give you a good idea of what we are looking for in terms of entries for both legs of our LEAPS Covered Calls positions. We'll revisit both of these paper trades in the future and see how we fared in the light of history.

It's hard to apply pure directional strategies in a rangebound market, but hopefully I've shown you how to use the tools at your disposal to carve out a modest profit center while we wait for the days of trending markets to return. The specific trades I have outlined in recent weeks are not really the important point. I really feel like I've accomplished something when I hear stories from you detailing how you have taken the lessons I provide and used them to create your own profitable trades. When you can do that consistently on your own, you will know you have graduated to the level where you are well equipped to direct your own financial future -- and that is a truly liberating place to be.

Learn the lessons, do the research and then take the trade with confidence.

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