A covered call writer has a specific set of goals and expectations, and his technical (chart) analysis therefore must be geared to his specific needs. The covered writer is not timing the stock and thus does not have to get direction and timing right; the covered writer only needs to avoid the bad ones. For these reasons, much of what you might have read about technical analysis in general may not be fully applicable to call writing. The covered writer might be well advised to avoid charts that make the timer’s heart race. The covered call writer seeks a chart without a lot of drama. The charting basics presented below will get you started in the proper (and safest) way to analyze stocks for writing covered calls, but many covered writers have learned to make consistent money with little more knowledge than I present below.
Before getting into analysis, let’s briefly cover the call writer’s unique perspective, because it informs the entire analytical process. A stock can go up, go down or move sideways. But that analytical approach is not terribly helpful for the covered writer. More realistically, a stock can go up a lot, go up a little, go down a lot, go down a little or move sideways in a narrow range – these are the Five Things a stock can do. The reason is that the covered writer makes the anticipated profit, or even more, if the stock goes up or sideways (3 of the 5), makes some money even if the stock goes down only a little (1 of 5), and loses money only if the stock really falls (1 of 5).
Even without careful fundamental or technical analysis, those are pretty good odds. But careful analysis really helps to control the known and knowable variables and put the odds in our favor. Without some knowledge of the chart, the call writer is limited and hampered.
Consider the power of this statement:
The call writer does not have to pick winners… only avoid picking losers.
This is a very liberating position in which to be. To achieve consistent success, the call writer only has to avoid writing calls on the dog stocks out there.
Just as a stock can go up, go down or hold price, a stock’s chart can reflect only one of three possible directions:
|Uptrending||The stock is in a pronounced upward trend, making successively higher highs and higher lows.|
|Downtrending||The stock is in a pronounced downward trend, making successively lower highs and lower lows.|
|Rangebound||The stock is trading in a sideways range between clearly defined support and resistance levels. This is a congestion pattern, and the stock likely will resume the trend in place when ranging began.|
A trend can be strong, moderate or gentle. A gentle (weak) trend is very gradual. Some trends are regularly punctuated by periods of ranging prices. And some stocks are so volatile that it is difficult to characterize the chart at all. The most important prices in trading generally are considered to be the closing prices. Thus a close above resistance or below support carries more significance than the mere fact that price briefly penetrated support or resistance during the period covered.
Clearly, each type of direction requires a different strategy. But first we must develop an opinion of what the stock’s direction is. Successful covered call writing does not require advanced technical analysis skills, but it is difficult to achieve consistent results without being able to at least size up the chart. We will first consider the basics of trend identification.
Like most things in nature, price action – of stocks, futures and entire markets – never moves in a straight line. Instead, prices move in fits and starts as traders and investors sell to take profits or buy to take advantage of perceived bargains. In an uptrend, for example, price soars for a period of time, then new buying slows and traders begin to take profits. This causes a pullback in price. As price pulls back to a support level, buying is renewed as traders deem the lower price attractive, which fuels a new upsurge in price. The same thing occurs in reverse during downtrends: an excess of selling over buying pushes the stock down. Eventually, the price fall usually slows as shorts begin to cover their short sales and as buyers deem the lower stock price attractive, which causes a new (and usually brief) uptrend.
As more buyers or sellers come in, the price action accelerates the prevailing trend, be it up or down. As bull markets continue, more and more buyers come off the sidelines and begin buying stock to move the market further. As bear markets run, buying dries up as long players move to the sidelines and greater short-selling occurs. More shorts gang up on the stocks. When buying is exhausted the stock falls or goes into a range. When selling is exhausted, the stock will then rise or settle into a price range.
A stock ranges, on the other hand, because there is not enough buying or selling energy to push the stock into either an uptrend or downtrend.
Those who believe that a chart holds no future assurance of price action are both right and wrong. The future direction of a stock or market cannot be absolutely predicted from a chart, meaning that even the best and most thoroughly reasoned assessment of a chart will not always be right. Extraneous factors such as news can affect price, despite the chart history. Still, charts have great utility for traders and for covered call writers precisely because they reveal the market’s sentiment about the stock.
When we see an uptrending stock begin to sell off, pull back to a support level and then begin a new advance, we are seeing the dynamic described above. Selling briefly overwhelmed buying as traders took profits from the stock. Short sellers, seeing the price weakness, began shorting the stock. As the stock pulled back, buyers who wanted in the stock at a better price began buying and shorts began covering their short sales as they realized the sell-off was slowing. The level at which the uptrend stalled is referred to as the resistance level, and the price level at which buying again overwhelmed selling is known as the support level. This is what the chart shows.
No trend lasts forever, and this is the reason. When the market loses faith that a stock is a bargain, or loses faith that it can continue to rise, selling increases and price either begins to range or goes into a decline. Similarly, when the market believes that a declining stock has become a bargain or that the sell-off will not continue, buying increases and either moves the stock into a price range or a new uptrend. It can be diagrammed like this:
|Uptrend||Buying > Selling|
|Downtrend||Selling > Buying|
|Trading Range||Buying = Selling|
Though a bit over-simplified, these dynamics are what the chart shows us. It is very helpful in call writing to be able to assess the stock’s direction and its strength. We often can assess that a price movement is only temporary, a natural “technical” movement.
That being said, once a stock has sold off from the top of its trading range and found support at the bottom, we often see that volume is flat or even decreasing on the new up-leg in the range! Though this contradicts the technical analysis books, it is easy to see this on any chart. This also happens frequently after a correction – the stock sails up, seemingly free of gravity.