The “stock market” actually is a blend of different major indices, listed below. There are too many indices to cover, but following are the major ones:
- Dow Jones Industrial Average (DJIA or INDU)
- S&P 500 Index (SPX)
- Nasdaq Composite Index (COMPX)
The DJIA is weighted by the prices of component stocks, whereas the SPX is weighted by both stock prices and the market capitalizations of component companies. This is why the DJIA sometimes is referred to as the “stupid” index; technical analysts tend to follow the SPX, while the public follows the DJIA. My writings tend to focus on the DJIA simply because the public is more attuned to it.
The Nasdaq is the technology index and frequently is dragged down, compared to the DJIA and SPX, by the many small technology companies that comprise it. In a market pullback or more lengthy decline, the Nasdaq often suffers more comparatively because of the flight to quality.
It is typical for the three indices to move in the same direction. When one or more of them varies from the others, the trading day is said to have been “mixed.” But as with stocks, what the covered writer focuses upon is the market’s trend. Technical analysis can be applied to these indices the same as to stocks. If the market is volatile or ranging, assess the reason for it. Do not get caught up in the financial press’ day-to-day speculation about what the market is doing: form your own outlook. If the major futures are down before the stock market open, the stock market usually will have a down day. Those who prefer to write stocks on a down day – when the market also is down – love these market pullback days.
Stocks do not follow the market in lockstep. To the contrary: the market indices reflect what the majority of stocks are doing. Thus a dropping market means most stocks are declining, and most are rising when the market is rising. But while most stocks are moving “with the market” (actually, moving the index), the fact is that some stocks are weaker and some are stronger than the market. For example, when the DJIA sells off 300 points, most stocks are falling, but some not by much and others hardly at all; and some can even rise. The number of advancing versus declining issues indicates the strength of a market movement.
All things being equal, the conservative writer looks for good stocks that are showing technical strength that is no less than that of the market, and preferably more strength. Following are some very general guidelines regarding conservative stock selection during different market phases. References to the “trend” mean observation of a daily chart unless otherwise specified.
Uptrending Market – Look for stocks in an uptrend, since there is little point selecting stocks weaker than the market. Be certain that a stock in a fairly recent uptrend is not merely approaching a resistance level on a weekly chart. Avoid stocks in a downtrend, even the household name stocks.
Ranging Market – In a narrowly-ranging (tight) market, look for stocks in an uptrend or also ranging. In a wide-ranging market, treat the down-legs as declines and the up-legs as advances, but the market seldom ranges this widely (e.g., most of 2004). Avoid stocks in a downtrend, even the household name stocks.
Downtrending Market – See the Trade Selection in Declining Markets summary in a future article.
Note that these are only guidelines and they only address short-term writes for the current or next month. They should not be applied with rigidly. For example, a large, healthy company that consistently offers good premium might be a desirable write even though in a long-term trading range when the market is strong. The great thing about a flexible approach to covered writing is how it frees the writer to use common sense.