Option Investor
Educational Article

NEWS FLASH - It's Still A Bear Market!

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For students of the equity markets, there are numerous lessons available for our continuing education every day. The challenge we face is determining where the important lesson of the day or week lies. It can be something as simple as learning about a new technical indicator and how it performs in specific market conditions or as complex as learning a new and advanced trading strategy. Of course the really important lessons are those that teach us what to do (or not do) to keep our account balances on the rise.

We have been talking about the LEAPS Covered Calls strategy in this column for 10 weeks now, and now that we have covered most of the nuances of the strategy, you should be getting a feel for how to utilize it in your arsenal of trading tools. For those just joining us, a quick review is in order.

The Covered Call strategy is ideally suited to a sideways market, whether we are speaking of the broad market, a specific sector like Semiconductors, or a specific stock like Intel (NASDAQ:INTC). The first step is to establish a long position in the stock (in our case, by purchasing a LEAP) as the stock recovers from a major support level with both daily and weekly Stochastics recovering from oversold. With a sideways market, we are looking to establish the long position so that we can profit when the stock begins to appreciate in the future. But if that isn't likely to happen in the near term, we can reduce our cost basis month after month by selling short-term calls, at or above the LEAP strike, each time the daily oscillators begin to fall back from overbought territory.

As options combination strategies go, Covered Calls on LEAPS is fairly straightforward. Not simple, but a very usable strategy for accomplished options traders. The biggest problem that arises with the strategy is trying to fit it into an unfavorable trading environment. Although there were signs in recent weeks that the markets would trend sideways until a bullish catalyst (like improving profits) appeared, recent market action (particularly in the techs) has dragged many stocks to new yearly lows, breaking support levels that were established in the March/April timeframe. While it doesn't invalidate the idea that we are in a sideways market, it forces us to evaluate what that trading range will be. And we now have to wait for a new base to build so that we can determine logical levels at which to enter new long term positions. We all make errors in judgment in the markets from time to time, but the critical question we all need to ask is, "Did I learn anything from the experience that will help me make a better decision next time?". If you can answer in the affirmative every time you trade, then you are on the right path.

To that end, I thought I would focus today on the demise of the Sun Microsystems (NASDAQ:SUNW) trade we have been following lately. After building what looked like a solid base through the month of July, SUNW looked like it would likely be trapped in a $14-23 trading range, a good candidate for LEAPS covered calls. So after deciding to play the stock in the LEAPS Portfolio, I decided to use it as a case study for our Covered Calls discussions in this column. I won't rehash our entries into either the LEAP or Covered Call sides of the trade -- interested readers can access those articles via the following links: Trade Management - The Key To Trading Success and LEAPS Covered Calls Trade Management - Target:SUNW. Rather, I think the important thing to cover here is how we would have exited the play last week when the company disappointed investors with its dismal mid-quarter conference call.

When we initiated the Portfolio play on SUNW in late July, we set our stop at the $12.50 level, just below the April lows. The thinking that went into that setting was that if SUNW were to break the April lows, it would be a very negative technical development; one that would clearly motivate us to be out of the play. As covered in the above-referenced articles, the first cycle on the Covered Call strategy went off without a hitch, allowing us to keep the accumulated premium and leaving us in a holding pattern as we waited for the price to pop up from the $13.50 level and give us another opportunity to sell calls.

That's where we were last week as SUNW issued their mid-quarter update...a conference call that was far from stellar. Since we didn't have an open Covered Call, the trade management only had to be applied to our SUNW LEAP. If our stop was violated, then we would want to exit the play, and that is exactly the situation we were faced with the day after SUNW's conference call. The stock opened well under $12 and proceeded lower from there. Holding onto the stock below that level falls into the category of Blind Hope, which has no relationship with good money management.

This is the important point to realize about the Covered Call strategy. While the premium received from the sold call can mitigate the damage, it can't protect you from a large selloff in the underlying stock. Now that SUNW has declined to new yearly lows, trying to game a bullish trade in the stock is dicey, at best. I went back and looked at the charts available to us up through the time our August Covered Call expired worthless, and there really is nothing to tell me that I made an error in judgment. Other than expecting that the stock would not decline to new yearly lows, that is.

This is one of those trades that looked good on every front, except perhaps from the standpoint of the underlying fundamentals, which were still unknown due to the unknown global economic picture. That picture has continued to worsen over the past 6 weeks, and as we have seen the bears take apart one stock after another, pushing them to new yearly lows. SUNW has not been any worse in this respect than its high-tech brethren, but it hasn't been immune either. There are some possible treatments to keep your investment account healthy in an unhealthy market environment. The first is to actively utilize stop losses to cut your losers short. That's a no-brainer and nothing new to you, my faithful readers.

The second possible way to protect your trading account is to harvest profits aggressively. This could have been applied to the SUNW trade by selling the LEAP as the stock began to weaken, eschewing the Covered Call strategy and instead focusing on locking in short-term profits. Of course that leaves one more key strategy that we can apply from a LEAPS standpoint -- LEAP Puts. That's right, we can buy LEAP puts to capitalize on extended moves to the downside. While I think we may be a bit late to this game for the current cycle, in the interest of education, we'll take a detailed look at how we might take that instrument next week and apply it to our goal of growing our investment accounts. In fact, we can use Spread strategies with LEAP Puts to put option premium in our account.

Tune in next week for a lower risk approach to trading the upside using LEAP Puts. I'm sure we'll all discover a couple nuggets of wisdom in the process.

Questions are always welcome!

Mark Phillips
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