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.
