9 Reasons Trades Go Bad

Many regard the stock market as a loser’s game in which only the lucky or wicked can prosper. Stock-picking and technical analysis don’t work, they will tell you: the stock market is like Las Vegas without the free drinks, and the house will get your money if you play long enough. But actually, the reverse is true: the consistently successful covered call writer is like a sniper who fires only when dead sure of the shot. There is such a thing as bad luck, of course, and we’ve all had some. But conservative covered call writing is not gambling, nor does it rely for its success on luck. It is an exercise in buying conservative stocks that will hold value and produce income, while designing trades so that the chances of success overwhelmingly are in our favor.

There are, in fact, only a few major reasons why trades go wrong. In each of the following factors, the harm is caused by the underlying stock selling off, yes; but the question is why does it sell off? The factors listed below are seen repeatedly through the years, and virtually all sell-offs will fit into one of these categories. Notice, as you read, how many of them are foreseeable and avoidable. It is important for covered call writing success that you understand them, because knowing what to avoid tells us what to look for.

While trade planning and management play important roles in your success, they will not make up the deficit if your trade selection is poor. When covered call trades pick our pockets it is almost always because one or more of these risk factors were at work:

  1. The stock’s fundamentals were poor, or shaky.

Generally, these are the poorly managed companies: those with deteriorating earnings, poor-quality earnings, no earnings or even no revenues. Its fortunes are uneven at best, or declining. Conservative call writing means focusing on the best companies, those growing revenues and earnings. Would you be comfortable holding the stock for the long term.

  1. Highly overvalued companies.

Some of these are quite decent companies. These typically exhibit a P/E that is significantly higher than the industry average. Some are well run, fine companies, but many are unprofitable or don’t even have revenues, and trade at forward (assumed future) earnings. Such stocks become overheated upon massive speculation and market hype; sooner or later, they sell off to a more rational price level. We want only the solid, profitable ones of this bunch and only after they have sold off and price has stabilized to a more reasonable valuation.

For example, a company with a P/E of 85 when the industry P/E is only 25 is highly overvalued, even though it might be a fine company. It trades at a high price because it is a fad stock and can fall precipitously if it falls out of fashion. By contrast, a company with a P/E of 40 when industry P/E is only 25 is a bit overvalued, but not dangerously so, since industry P/E’s are only averages. A company with a P/E lower than the industry average is not better or more conservative.

  1. A bearish trend or developing bearish chart pattern.

This category includes bearish trends and bearish chart patterns in general. Chart reading will never be 100% predictive, because of the effects of news concerning the company, the industry and extraneous factors (e.g., 9-11). Covered call writing success is considerably heightened by the ability to recognize obvious warning signs on the chart. I have many times found that bad trades provided ample technical warning that went unheeded, or unseen.

  1. Significant news was known to be due on the stock.

This refers to a pending news event that is significant in relation to the company and its prospects. What moves a smaller company like an earthquake might not muss the hair of a large-cap company. A stock can rise (or fall) on good news and usually falls on bad news. News events can range from the fairly mundane to life-and-death, and includes earnings announcements. Tip-off: implied volatility that is meaningfully higher than historical volatility. There are others that we will see a little further on.

  1. Rumor spike situations.

Buying a price spike is dangerous when it has far outrun support, because there is no way of knowing if price can be sustained there. This category includes the “buy on rumor, sell on news” situations in which the stock has spiked up on anticipated news and may sell off even if the news is good, if there are no more buyers. The greater the price run-up that occurs before news, the bigger and better the news has to be in order to keep the stock rising.

  1. Seasonal or declining company fortunes.

Some stocks are subject to seasonal vicissitudes: poor Christmas sales for a retailer, a warm winter for sales of heating oil, etc. Similarly, the market tends to rise November–April and then fall through the May-October period. Though annoying, the companies usually recover. Far more dangerous is the company whose prospects are declining, due to loss of market share, poor management and similar reasons. This is one arena where massive insider selling constitutes a clear warning.

  1. Small, manipulated and highly volatile stocks.

The smaller, less liquid (and frequently lower-quality) stocks are, the more dangerous for the covered call writer, at least statistically. Add in high price volatility and the company becomes extremely dangerous. Companies with small floats easily can be – and are – manipulated by market makers and traders; this is why small stocks can move 10-15% on no or very little news. Small-cap companies work best in the first half of a bull market, but usually lack a deep and liquid market. High option premium coupled with low open interest and low option volume are dangerous signs, since it should be demand for the options that is pushing premium high.

Even a larger and quite liquid company that is highly volatile can be dangerous when the covered call is not put-protected. For example, in 2006, Rambus (RMBS) tanked from $48 to $10 (-80%) in less than four months. And 2007 saw it back over $23, then down to $12 and back up to $20: price movement of over 50% in a few months. Such stocks are for traders, not conservative call writers.

  1. The industry or the overall market sells off.

Market – When the market sells off, it will carry most stocks down with it; not all, perhaps, but most. Market corrections are healthy events in a bull market. Investors often take needless whipsaw losses in falling markets from selling out positions during the correction, only to watch the stocks generally recover with the market. And many investors do not properly adapt the covered call strategy to a declining market, which I hope to correct!

Industry – Companies tend to sell off with their industries; the best may fight the tide, perhaps, but don’t count on it. Selecting a stock in a declining industry is asking for a declining stock. If the industry is not in serious decline, then it may only be of minor concern, but the weaker the industry, the stronger a stock in that industry needs to be for the covered call writer. The ideal, obviously, is a strong company in a strong industry. An industry going into rotation (selling off) is even more worrisome because it can be expected to last much longer than a market correction, especially where the industry’s prospects are deemed seriously and long-term impaired (e.g., housing in 2007).

  1. Good old-fashioned bad luck.

These are the unexpected events out of the blue that the most careful analysis could not have revealed or predicted. Insiders and their followers sometimes know (and act on) the “unforeseen” news, but not always. Such news can range from merely not good to disastrous. The smaller, the weaker, the more overvalued, the company the worse it will be hit, as a general matter. Notice a pattern here? Fortunately, the larger, excellent companies don’t get seriously hit nearly as often as smaller, weaker ones and tend not to stay down long when they do. But even big ones can be hit.

I understand that the market offers up surprises occasionally, and that the highest level of diligence cannot comprehend all variables. Bad news on Intel Corp. (INTC), for example, might send the entire semi-conductor industry into a tailspin. But the genuine surprise out of left field is about one-tenth as common a cause of losses, in my experience, as missing clear signs of a problem in the trade.

But we can rationally distinguish between trades that truly go wrong without warning and those that actually gave ample warning – like the rattler’s rattle – of the bite to come. We all miss important information on occasion, or misjudge the likely effects of an impending event such as earnings. But the overwhelming majority of bad covered call trades will fit into one of the above categories.

For example, when earnings of a highly profitable company falter, the poor earnings may be a surprise, but the existence and timing of the earnings release, which is known to the market, should have been known to the investor. We certainly should be aware of any earnings guidance already issued by the company. One holding the stock through earnings should be aware that 1) earnings might not hit the consensus number, 2) current earnings might be fine but the company could announce lower earnings expectations for future quarters, or 3) earnings might be fine, but the stock has risen on earnings anticipation and all buyers already are in. In either of these events, the stock could pull back, and in the case of 1) and 2) it could really sell off. What we could not do in this situation, in all fairness, is complain about the vagaries of investing, because we knew or should have known there was earnings risk.

This is a major point to note in the covered call game: Reasons #1 – #7 were not random, nor luck-based. Every one of them was knowable. We might not have known in advance whether the news would be bad or good (e.g., earnings, FDA approval) nor exactly how bad or good it would be. But if we plan to write a stock across earnings, or across a major event like a drug approval, we must know it and be positioned for bad news. We must also be prepared for a sell-off on good news if too many traders already bought the rumor. People often claim to have been surprised by a selloff, when for example they had no idea a drug approval or earnings release was pending; or perhaps didn’t bother to look at a chart that was quite negative. But this is just a failure of analysis: patience and discipline.

Note that the trade can be affected by more than one of these issues. Suppose it is a stock with poor fundamentals (#1) that is outlandishly overpriced (#2), and it has moved up significantly over several weeks (#5) in anticipation of a ruling in a vitally important lawsuit (#4). Trades exhibiting multiple warning signs do occur. Only the unwary write calls on them without protection. As you might expect, when any of these bad results occurs, it typically will have a proportionally greater effect on the smaller, weaker or unprofitable companies – the “usual suspects” of the stock market.

Once we have eliminated companies displaying these obvious risks, the only thing left to hurt us in a trade is bad luck – those unforeseeable rattler bites. They luckily don’t happen too often, and the proven elements of trade selection and planning help to ameliorate their worst effects. And when we confine our writing to the best companies, we not only have more consistent wins – these are the stocks that tend to come back even if they fall. The reason: they are the ones people want to own.

Here is an extremely important hint for improving performance: it is important to do post-mortem reviews on trades that go badly or that gave us a good scare. What went wrong? Did we not do the basic trade analysis? Did we miss something? Did we react in panic to a move? We can assume that good trades worked as planned because they were properly selected and planned. While we all bemoan the bad trades, I have learned far more from them than from the good ones. Investors who engage in this post-mortem analytical process advance themselves considerably.