Last week we focused on what I think is the key to trading success - trade management after we have entered the position. We want to have an exit strategy laid out before we actually jump into a position, but more importantly, we need to stick to that strategy when our exit conditions are satisfied. Greed, fear and hope are the enemies that are constantly plotting to drag us off our carefully crafted course to profits.
Because it provides an excellent example of the issues we are faced with in many trades, I'm going to continue to focus on our recent SUNW trade. And as I promised last week, I'm going to address the trade from the perspective of an investor who wanted to hold the position for a longer period of time, writing covered calls in order to consistently lower their cost basis. So let's start with a brief review of how we entered the long leg of the trade. The following excerpt and chart are from last week's column:
"Remember when we took our LEAPS entry on SUNW as it bounced from $14.10 on July 24th? It was a near-perfect setup, as the stock was bouncing from major support and both the daily and weekly Stochastics were showing us bullish ascent patterns. We were able to set a fairly tight stop at $12.50, setting up a limited risk and attractive reward play."
We noted at the time that based on recent trading history, SUNW would likely trade in the $14-23 range until a concrete reason to buy Tech stocks emerged. And even though the stock did briefly test the $23.50 level in May, $20 looks like the real ceiling we should be focusing on. On the downside, SUNW shouldn't take out its spring lows unless the NASDAQ completely melts down, allowing us to place a fairly tight $12.50 stop loss.
So we had our long position and just had to wait for the daily Stochastics to roll over from overbought territory to give us our Covered Call entry. The first week of August delivered just what we were waiting for, as the stock lost its upward momentum and looked to be headed south from the $18 level. On August 7th, aggressive traders could have sold the AUG-17.5 call (SUQ-HW) for $0.50-0.60, while more conservative traders would have targeted the SEP-20 call (SUQ-ID) for $0.40-0.50. While not a huge premium, it is a start for those looking to pay off their 2004 LEAPS over the next several months. Afterall, they still have 28 months of time before expiration in January 2004.
While straight LEAP traders (those uninterested in Covered Calls) would have been tightening up their stops or just taking profits as SUNW fell back from the $18 level, Covered Calls traders have a different objective...long-term appreciation of a LEAP where the cost basis has been whittled down to zero. Accordingly, for the Covered Call players, the smart move would be to leave their stop at the $12.50 level.
As the stock has continued to decline, they have watched all the short-term gains in their LEAP evaporate, but last week's weakness resulted in a stress-free worthless expiration of their August calls. Now the stock is once again trading near (actually just below) the $14 level and we now have to bide our time until the daily stochastics once again reach overbought. Then it will be time to watch for another opportunity to sell short-term calls and take in a bit more premium.
As a matter of fact, traders that missed the first LEAPS entry could be looking at a fresh entry opportunity into the play with the stock actually trading below our initial entry point and daily stochastics deep in oversold. The one concern here (and the primary reason SUNW didn't go right back onto the Watch List last weekend) is the weekly stochastics (not shown), which is still declining. The next high odds entry point for SUNW LEAPS will come as both the weekly and daily stochastics rise from oversold territory, so long as the $12.50 level isn't violated on the downside. In keeping with our theme of following a trading plan, we need to stick to that stop loss level. It is there to keep us out of the situation where a slight loss grows into a devastating loss. Ignoring our stop and hoping that it will come back is a dangerous practice and one destined to fail over the long run. Should our stop be violated, then we'll have to buy back our short-term call and then sell the LEAP, likely for a small loss. I don't think that is where the trade is headed (otherwise I wouldn't use SUNW as an example), but if I end up being wrong, you'll get another educational example with the nitty-gritty exit details in a future column.
Similar to our detailed treatment of the AOL Covered Calls trade in June, I'll continue to follow the SUNW trade in the interest of continuing education. Right now it looks like it could go either way. It could be a long-term winner, or we may be forced to cut our losses on an additional sharp drop in Tech stocks. I'm currently leaning to the winning side, but stay tuned for the adventure. SUNW could be locked in this trading range for several months, and so long as it doesn't break out in either direction, it should be fertile ground for selling premium and whittling away at our cost basis.
Here's a quick bonus that caught my attention today. I was browsing through the plays currently sitting in the LEAPS portfolio and noticed that our ABX play is looking a little weak. Stochastics have topped out on the daily chart, and while I'm not wild about tightening up our stops just yet, it looks like a good opportunity for selling some premium. This is another one with cheap options, so to overcome the commission costs associated with selling front-month calls we need to do the trade in volume. Take a look at the chart below and see if you see what I do.
Due to the cheap premiums, I'd look to sell the calls on an intraday surge above $17, and use the $17.50 strike. It looks like the stock is going to need some more horsepower to clear that level and we can take in some premium in the meantime.
As always, lay out your gameplan in advance of entering the play. Then when your conditions are satisfied, you can take the entry or exit with confidence, knowing that your decision is based on a sound logic, not the greed, fear and hope of the moment.
Questions are always welcome!