A common mistake made by those new to covered call writing is to consult a daily chart only. However, it is necessary to also view a weekly chart to get a better feel for what the stock is doing in the bigger picture.
Figure 7.17: BJS Services (daily chart)
BJS seems at Figure 7.17 to have halted the precipitous price slide that occurred through most of December 2006, a chart pattern I refer to as “Angel Falls” or “Falling Piano.” In fact, the stock seems to be showing a bit of strength, inching its way up through the first six months of 2007.
BJS kept making higher highs and higher lows, though not with any real steam, helped no doubt by a then-rising market.
Figure 7.18: BJS Services (weekly chart)
But this brief uptrend is not the whole story. A weekly chart shows BJS through a wider lens, and we can see the news is not good.
Figure 7.18 includes the 5-month period shown on the preceding daily chart, painting a grim picture. The late-December 2006 sell-off that began the daily chart is revealed to have been BJS’ failure to even get back to the weekly trendline.
And the tidy advance in early 2007 is revealed to be a new test of the weekly trendline. Without consulting the weekly chart we could not know this.
Though not shown on figure 7.18, the September test of the trendline failed dismally. And while that was not a certain outcome at the time, the trendline test (and the startlingly poor performance of BJS all through 2006) was obvious on a weekly chart. Anyone thinking at the time to write BJS would have been amply warned of its weakness by the weekly chart.
Yet could BJS have been written during this brief up-leg? Yes, of course; the stock could have written using in-the-money, at-the-money or even out-of-the-money calls. The reason is that, despite the ghastly major trend, BJS undeniably was enjoying a brief surge. The fact that the move was only a brief reaction rally headed back to test the weekly trendline does not in any way invalidate the rally. The real question to ask ourselves is whether we are willing to own the stock longer term should it break down. And, were there no better writes to be found?
The choice of call strike would have depended primarily on the writer’s degree of conservatism – using the term descriptively, not pejoratively. Very conservative writers likely would choose the in-the-money strike for more downside protection, not trusting the stock very much. More aggressive writers would choose the out-of-the money calls, looking for the bigger return if called – or even if not called, provided the stock had risen.
The next example is a bit more subtle, but instructive. Figure 7.19 below is a daily chart that shows Gold Fields Int. (GFI) price action for the period from September 2006 through April 2007. GFI appears to have gone into a $3.00 range, from $16.50 to $19.50.
Figure 7.19 – Gold Fields International (daily chart)
A point of interest: note how all but two of the option expirations (dotted lines) fell at the low points in the range. While out-of-the-money call writes would have prospered if put on after each expiration that fell at a range low, such writes would have made sense only if put on with the intention of closing them early – exploiting the low delta of the out-of-the-money calls.
However, looking at GFI on a weekly chart, shown as Figure 7.20, yields a picture that is less-reassuring. GFI had recently completed what seems to be a head-and-shoulders pattern, which is a reversal pattern.
Figure 7.20: Gold Fields (weekly chart)
Though the bottom of the range had not broken below the neckline formed by the head-and-shoulders pattern, GFI was showing minimal strength. The consolidation (ranging) pattern usually is a brief one that results when neither bulls nor bears can quite get the upper hand. When the ranging behavior ends the stock will break out to the upside or downside.
A strong reversal pattern such as a head-and-shoulders on a weekly chart can presage a very long period of decline. Unless and until GFI were to show a conclusive strength, it remained suspect in mid-April 2007. Though the weekly chart could have presented an even grimmer picture (as did Figure 7.18), Figure 7.21 shows how events ultimately transpired:
Figure 7.21 – Gold Fields International (weekly chart)
Though I concede that few could have predicted GFI’s fate with certainty in mid-April 2007, it thereafter exhibited the technical weakness we would expect after such a powerful reversal pattern. Because covered call writing is to a large extent about which stocks NOT to write, GFI was giving fair warning at this time.
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The foregoing is only a “quick primer” on the basics of chart analysis as it pertains to covered call writing. Chart analysis is a subjective art, not a true science, and except in the clearest of cases, technicians can and do disagree. The greatest chart analysts get it wrong at times; and so will you. But while charting is by no means foolproof, it is too valuable a tool to be ignored – particularly when the chart attempts to warn us off a stock.
If we cannot assess a stock’s likely direction to a degree that allows comfort in placing the trade, it is best to find another trade. If in doubt, leave it out. We can’t lose money on a trade we don’t place.
But if we use the simple guidelines in this article for assessing trends and ranges, and identifying ranges and support and resistance levels (including the use of trend lines and moving averages), we should be able to write covered calls with consistent profitability.
The essence of selecting stocks for covered call writing is to try to divine what the stock is most likely to do over the expected duration of the trade. If we are looking at a 3-week trade, or a 3-day trade, we primarily want to know what to expect of the stock during that general time frame. But since it is possible that we won’t be called out and that the stock could pull back, we must develop an outlook for the medium term.
As noted in the subsequent articles on trade selection, we should pay attention first to the chart period that is most relevant to the trade’s duration, but we should always view the stock on a weekly chart to get a feel for the medium-term direction. It is possible to take a short-term covered write on a stock with a pleasing daily chart even though the weekly chart shows weakness. I have done it many times, chiefly writing out-of-the-money calls with the intent of closing the trade early on the stock’s short term rise. But to enter a trade solely on that pleasing daily chart is a practice unwise in the extreme.
I urge that all covered writers learn to recognize common technical patterns, such and head-and-shoulders, double-tops and -bottoms and others. My favorite writer on technical analysis (or “TA”) is the old master, John J. Murphy, and I highly recommend his ground-breaking book, Technical Analysis of the Financial Markets. There are dozens of TA books around, but nobody is more thorough or easier to understand.