Monday, August 4, 2008

Investor Emotion and the Market

Certainly the current trading environment during the unwinding of the credit mess can be likened to a ride on a rollercoaster with high volatility being the daily norm rather than the exception. Many traders and investors--institutional and otherwise--have been suffering the effects including sleepless nights. One such person is my friend and colleague, Jeff, who is now retired and leading the life of the idle rich after a successful stint as the manager of an equities portfolio. Jeff's approach to investing is basically fundamental. Before he buys stock in any company, he makes sure to kick all the tires which typically includes poring over balance sheets and analyst reports, visiting prospective companies and jawing with management--in essence, doing all of those boring due-diligence things that a good investor should do. Now that he's retired, he decided it was time to kick back and enjoy life and doing all of those things that retired Masters of the Universe do. But he still wants to keep a hand in the market; he just doesn't want to spend too much time at it so he thought that writing covered calls would be the perfect low-key strategy to generate monthly income. (See Recipe #7) Great idea, but that's not how it's working out for him. What's going wrong?

Do you know your level of risk-taking?
He called me last Friday afternoon with more than a hint of exasperation in his voice saying that he wrote a covered call on United States Steel (X) and doesn't know what to do. Instead of freeing him up, he's spending every market minute glued to his computer screen watching the price movement in X and said that all of the stock's recent volatility is driving him crazy. "What should I do if the stock shoots way up past the strike price of the sold call? If the stock tanks, do I have any downside protection, and if not, what then?" I can hardly blame him for worrying about the price movement in any of the stocks in the energy or materials sectors as they've all been on Mr. Toad's Wild Ride lately. You would think, however, with all of his professional experience in the stock market that the covered call strategy would be a piece of cake for him...but that doesn't seem to be the case. It became apparent to me that he's had little (if any) hands-on options experience--not that there's anything wrong with it but it does illustrate two points that I keep making from time to time and those are 1. Know your trading tolerance and 2. Don't trade any new strategy without thoroughly understanding it and paper-trading it first.

Of course I didn't browbeat him with these maxims and suggested a few alternate low-risk strategies. (One is selecting good dividend paying stocks, a strategy that I'm currently devising and will be up on the blog in the near future.) As I was completely burned out last Friday and was eager to get to the beach, I wasn't up for solving the problem of what should he do with his X covered calls, and now I feel that I should do that today as a courtesy to my frustrated friend and as a tutorial for those of you out there who might be feeling like you're in over head with your own covered calls.

Covered call plays on United States Steel
The daily chart below of X clearly shows four support/resistance levels. The stock began its meteoric run last October (not shown in the below chart) rising in steps from $62 to its high of $196 in June. I don't know at what price my friend bought his stock, but one excellent time to write a covered call would have been on June 10th when the stock bounced off $185, a resistance level tested once before. Another good time would have been when that level was broken on July 1st. The following day the stock dropped an ugly 17% also breaking the major $170 support level. This was the time to either close out the covered call by buying it back (for probably pennies) or roll it down into a lower strike price. Breaking two major support levels in the span of only two days usually bodes badly for the stock in question, so had I held United States Steel, I may have been sorely tempted to sell the stock as well. That move sure would have saved me a lot of upcoming grief, but hindsight is 20/20. (Click on the chart for a larger view.)

Had I held onto it, another good place to sell either the stock or the covered call would have been when it hit $170, a support level now turned into resistance. In just the past four trading days, the stock is down about 16% and is testing its $140 resistance. Another bearish day for the materials and I'll venture the stock will be heading back down to its $120 break-out level in no time flat, giving one another opportunity to write a call (at the $140 level)--assuming the strike price of the option is still above the purchase price of the stock.

What if the stock had gone a lot higher?
One of Jeff's issues was that at one point the stock was getting too high and he feared assignment. That is a valid concern to some, but to most people who play covered calls for income, getting assigned is exactly what they want. Sure, they lose out in further price appreciation, but their original goal is to get the assigned return. They're generally not interested in writing monthly covered calls on the same stock because they know they might not get a decent return next month due to possible lower options volatility or the lack of a suitable technical entry point.

Remember that writing covered calls requires a fundamental knowledge of options dynamics as well as basic chart-reading savvy. Knowledge combined with skill will not only fuel your portfolio to profits but you'll sleep better, too. Understanding support and resistance levels will lead to informed trading decisions and form the basis of setting buy and sell alerts, but only you know your level of risk tolerance. The moral of this story is to not trade over your knowledge nor over your comfort level.

So, what can my friend Jeff do now? If I were in his position, I would buy back the calls and sell the stock. Or, if I didn't want to part with the stock, I would either collar it by buying a put and selling a call, or buy the SMN, the Ultra-Short Basic Materials ETF which made a convincing break above its $35 resistance.

I hope that Jeff can now get back to leading the life of the idle rich, for it pains me to see him suffer so. (Just kidding, Jeff.)

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