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Always Trade with Your Edge

Always Trade with Your Edge

Courtesy of Rev Todd

As I near the first option expiration next Friday during my one year plot to make 3% a month for a year, I know I won’t make 3% the first month and I am OK with that.  I did not fully invest right away and phased in investments as I found stock patterns that fit my philosophy.  After three weeks I am still not fully invested.  I will probably make up ground by October because I have put in a number of positions already that will make more than 3%, so I’m not going to go crazy trying to hit my target every month.  While I want to make money, I’m going to meet that goal by not losing money and not taking unnecessary risk.  I believe I will still meet my overall goal without 3 percent this month by following this simple advice:

Always trade with an edge. 

What is the trading edge when writing monthly covered calls?  I am trying to take advantage of one of the three certainties in life – death, taxes and premium decay on options.  I don’t know what the stock market or the company I invest in will do. I do know with certainty that when I sell an option I will get paid and the premium will drain to zero by the third Friday of the next month.  I sell monthly options because the premium is compressed to a greater degree than LEAPS (long-term) options.  My first edge is very simple, sell premium that allows for 3 percent in profit per month.  Since my current bias is that the market is ranging, I’m playing it safe and writing in-the-money calls that allow for a 5 to 10 percent downside protection, which seems reasonably safe for now.

I never write a covered call on a stock just because of a compelling premium.  My goal is to make a stable income on the stock every month, not to speculate.  High premiums are a sign of high volatility in the stock, which makes the investment more speculative.  I want a high degree of certainty, so I follow some basic rules, which you can see in every trade alert I post.  These rules are my second edge.  The most important rule is that I always invest in stocks on an uptrend.  No matter how much I like a stock, I don’t write a covered call on a falling knife.  I write covered calls based on technical indicators that generally lead to increasing prices and stability.  The major two indicators I use are moving averages and volume. 

I find moving average very helpful in giving confidence (not certainty) in picking stocks.  Two books I find helpful on this include “The Ivy Virtual Portfolio” by Mebane Faber and “Trend Following” by Michael Covey.  Faber has a simple and compelling premise to investing.  Buy major asset classes such as stocks, commodities, bonds and REITs when they are above their 200 day moving averages, and go to cash when they are below the average.  He found that this philosophy returns 10 percent a year on average every year, with only one small loss in 2008.  Not a bad return for looking at your virtual portfolio once a month to see what the moving averages look like.  Covey demonstrates the power of moving average crossovers (such as when the 50 day MA rises above the 200 day MA or falls below causing the infamous “death cross.”).  It is not hard to make about 10 percent of year following these crossovers as well.  People follow crossovers because they have reasonable predictive power over the long haul and they are simple to see without a ton of specialized knowledge.   

I like to see a stock above the three major moving averages, the 20, 50 and 200-day MAs.  Ideally I would like to see the stock either with some kind of bullish crossover happening (like the price crossing the MAs or the 20 MA crossing the 50 MA) or the stock has just tested support at a moving average and is starting a climb back up.  I don’t want a stock that has climbed too high and is testing resistance.  Then it is due for a fall and I may be soon down to my cost basis.  I will also use these moving averages as my support areas.  When I write the stock, I look to see if my cost basis is going to be below a major moving average support point.  If you read my buy alerts, you can see in each one that I have tried to have net cost below support.  This gives me some confidence that I won’t lose money.  It also gives me a point at which I either get out of the trade with a small loss or roll down and out to the next month to capture more premium.

Volume is my second technical edge.  Once I find a stock with this kind of positive chart movement, I want to confirm the move by looking at the volume.  Is the stocks move marked by an increase in volume?  That is a signal that other people want the stock too and the big money of institutional investors may be stepping in.  If a stock is rising in price and volume, I’m going to check it more closely.  If the price is going up, but the volume is going down, I’m going to wait and look more closely.  The stock may be topping out and ready for a fall.  I will put in on the watch list and wait for at least steady volume.  I sometimes look at volume momentum indicators, but mostly I like a standard daily volume bar chart.

These are not the only chart patterns you can base covered call writes on, but they are my basics.  You can look at cup-with-a-handle breakouts, 52-week new highs, positive reversal candlesticks, falling wedges or stocks beaten down and coming off the bottom, but I mostly write based on moving averages and volumes.  It takes about 5 seconds to decide if I like the chart pattern and volume.  Then I make sure the stock has liquidity through its open interest, check the news for any warning signs and buy away. 

The bottom line is to be patient and let the trade come to you.  Keep a watch list of candidates they meet most of your criteria, but wait till the stock proves itself.  For example, I am a big fan of GLW and would like to jump in.  It has recently come off a bottom and climbed above its 20 day MA.  This makes it a great candidate for discount writes in your margin account the Phil likes at PSW.  I watched the stock this week and it stalled at the 50 day MA and dropped 50 cents again.  When the price gets above both the 20 and 50 day MAs and holds for a day or two, then I will jump into a monthly covered call.  I have the opposite problem with CAT.  It has gone up to near its high point and is well above its MAs.  As long as I think the market is in a trading range, I’m concerned CAT is topping and may fall in the next month.  I will watch and see if it comes down and bounces off the moving averages.  There is a strong possibility I will write the stock for November if the scenario arises.  So be patient and follow the watch list on quality stocks.  You only need about 10 or 12 good stocks a month to write.  If I only make one or two percent some month because I wasn’t fully invested, so what?  I’m not going to lose money either.  At some point I will be bullish on the market and make 4 to 5 percent on at-the-money or even out-of-the money-calls and I will be right there at 3 percent a month on average.  But if I have a big losing month and I’m 10 percent down because I was reckless and greedy, I’m going to spend three months just catching up.  It is a lot like fishing.  You can’t put the fish on the hook, you have to wait for it to come to you.

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  1. good article rev,
    i have done this successfully several times with nucor (NUE); may want to add to your list.

  2.  Rev, i left you a comment on your blog.

  3.  bps2002 – I like the NUE chart and how is moving up right now.  I think it could work.  I want to see what the China buzz is on Monday before getting into new trades this week.  Another one for the watch list which I’ll add to the site.

  4. good article rev; interesting strategy … gl

  5. Good article REV only one question where do I find your site thks

  6.  yodi – just click on the user id and it will take you to the site or bookmark

  7. Rev --
    I think you’re on the right track.  Selling premium is the way to go.  However, I think Phil said it best on 9/3:

    8%/Exec – I meant net 8% more than just doing a buy/write and worrying/working a lot less on the position.  So if you think you can make 2% a month if all goes well with your call selling vs a buy/write that pays 14% then you have a net 8% advantage but only if things go perfectly.  What I’m saying is that out of 12 2% sales, it’s very likely that 1/3 of them (8%) are likely not to pay off and you have to roll or buy back and your return is not likely to be better than a buy/write, which is why I favor the "set and forget" strategy.  Also, if I buy IBM for $125 and sell $30 worth of 2012 $120 puts and calls then I’m in for $95/107.50 with 26% upside.  That means I have $30 of cash to play with on short-term positions.  If I instead sell the Oct $125 call for $4, I have a 3.4% potential gain over 6 weeks but only $4 to play with while I wait and, of course, if IBM drops $10, my first and second months of sales are wiped out and now I have to sell $115 calls to get even and if IBM goes back to $125, I’m screwed again. 
    So, with a buy/write.  I enter IBM at $95/107.50 and IBM drops to $115 and I don’t care and it goes back to $125 and I don’t care and I’ve got $30 that I can sell 2x XLF $14 puts against for .35 to collect another .70 (which is a respectable $8.40 a year).
    With the covered call, you enter IBM at net $121 but the stock drops to $115 and you cover with the $115 calls at $4, dropping your net to $117 but then it goes back to $125 and you are either called away at $114 with a net $3 loss or you roll them and wait another month to see if you can eek out your first dime of profit in month 3.

    This is a very good summary of the typical problems of covered call writing, over the long term (like a year or two, especially writing front-month calls.  Stock goes up?  Fine.  Stock stays the same?  Fine.  Goes down a little bit? Fine.  No problem.  But then there will be those corrections (which seem to happen two or three times a year) that can wipe out months of premium, and will leave you with difficult decisions to deal with.
    Like Phil’s example of IBM, above, it goes down to 115, and what do you do?  Write at 115, locking in a loss?  Or, write at your adjusted basis?  Or do you keep writing at $125, hoping that the stock returns to $125, so a loss can be avoided? Or do you switch to a long term write, getting more premium to make up for the loss, but tying up your capital for months?
    The answers to these questions are difficult.  I’ve had to deal with many of them.  As a result, I have moved away from the strategy you have described.  Like Phil said, perhaps 8 months out of the year, it works, but the other four months are painful indeed.

  8. Rev… very well written strategy.  Many of us have been engaged in call writing, but it is very beneficial to revisit the strategy from time to time. I, personally try to blend this strategy with a good feel for the market direction.  At the moment, I believe it is somewhat dangerous to get very deep into short call positions, as I believe the market is suceptable to some serious down movement.  I assume you roll for better position, in order to keep your risk at a comfortable level.  I have a question – do you also sell puts for income generation?  I admire you, and the wonderful things you do for the less advantaged.

  9. REV, you may want to consider both xle and iwm for covered calls. 51 is bottom of the channel for xle and 59 for iwm. I usualy sell front month 55 calls on xle. thankfully, bp isnt in xle! both of these etf’s offer pretty good premiums within the safety of a etf (less headline risk)

  10.  escohen5 – I agree with Phil about the hazards of dealing with short-term covered call writes, so this strategy does take a lot of adjusting during the down times.  I think it is probably best to mix a long-term and short-term approach.  I tend to emphasize the Phil’s discount writes in my margin account.  That said, I started covered call writing in September 2008, lost money, but not nearly as much as people using traditional mutual fund, financial planning strategies.  In the future, I will be adding articles about adjustments and rolling calls to cut losses and gain profits.  I had good success after the huge market drop because premiums were very high.  I made back ground quickly just trading calls during the volatility.  I’d sell the calls one day, let them drop and buy them back, wait a couple of days and sell again.  I traded calls two or three times a month on the same stock during that time period.  I won’t say it wasn’t a little nerve racking, but I bet many of us went to bed with a sinking feeling during that time period.  

  11.  gel1 – I do sell puts in my margin account to generate income.  I tend to follow Phil’s discount strategy fairly closely in that account.  I like the flexibility of put writes because of the low margin costs and the ability to easily roll puts in a margin account.  I tend not to do this in the IRA, because I have to put up full cash for writing the put.  If I have to put up full value, I would just as soon buy the stock and write a call on it.  

  12.  jomamma – Good point that the ETFs have less headline risk as a basket of stocks, though the return is lower.  If I feel bullish on a sector like that, I would lean to an out of the money write, or a leg in.  Buy the ETF, give it a few days and if it goes up write the calls with some capital gains already started.

  13. revtodd/all :
    Very good article. I like  the 200MDA comment.I prefer the dividend paying stocks and selling leaps to reduce my risks.I won’t make 3 % /month but if I can make 15 to 18%/yr. without too much worry, I’m happy. 
    Several weeks ago, I  subscribed to which is a great site for selecting covered calls,strangle,straddles & for any other option combination. If you select a covered call ,it does all the mathincluding probabilities of getting called,% downside protection, total return,etc.  and offers alternatives for new  or existing positions.Cost is about $60/ month and  I have already made enough to pay for 2 yrs. subscription.Lots of time saved in calculating returns  for various options. Great site for ideas. Take a look. If you subscribe, use DFLAM as referral since I’ll get a 1 month addition to my subscription. 

  14. It is my understanding that you cannot short the market in a IRA, but you can go long inverse ETFs.  Seems to me, using 20-30% of your portfolio  in SH, SDS, QID, TZA, or FAZ   options should adequately protect your long stock positions. So even if IBM, CAT, or whatever should drop 5-10% in a week, your portfolio will not.

  15. It is my understanding that you cannot short the market in a IRA, but you can go long inverse ETFs.  Seems to me, using 20-30% of your portfolio  in SH, SDS, QID, TZA, or FAZ   options should adequately protect your long stock positions. So even if IBM, CAT, or whatever should drop 5-10% in a week, your portfolio will not.