Lesson 3: Timing and Technical Indicators In this chapter, we will be focusing on the timing of the trade, from each individual angle. Timing plays a critical role in a Covered Call strategy, as it can help you avoid being assigned at expiration, can help you enhance returns with better call premiums, and can help you avoid losing money on the underlying stock in weak market conditions. Here are a few specifics we ll be discussing in this chapter: Timing the Market and Market Indicators Timing the Purchase of Stock Timing the Sale of a Call Timing Trades Around Expiration Cycles Timing the Market As you are well aware, not all market conditions are conducive to owning stock. However, any market condition is a good market condition for our Covered Call strategy. Even in a bearish market environment, it is possible to generate good returns with our trading strategy. However, to be consistently profitable in tougher market conditions, you ll need to put a lot of emphasis on the timing of the trade. The first element of timing we ll discuss in this chapter is market timing. Market timing is not an exact science, and with a longer term time horizon, you ll have plenty of latitude with the timing of a stock purchase. In general, you ll want to avoid overbought market conditions for purchasing stock, and avoid oversold market conditions for selling calls. One of our favorite market timing indicators is the McClellan oscillator. The McClellan is a market breadth indicator that calculates the difference between the number of advancing issues versus declining issues on the NYSE. It does a fantastic job of signaling overbought and oversold market conditions, when these conditions are not outright obvious. The image below is provided by Stockcharts.com, and illustrates the McClellan over a 3 year period. I ve drawn lines at the +70 and -70 areas, which depict overbought and oversold levels. At the time the market reaches these levels, it is typically due for a significant reversal.
As a market timing indicator, the McClellan is a tool we consistently use to measure the points in which the market is due for a reversal. As a timing indicator, if you are looking to purchase shares of stock, but want to time the purchase and the market simultaneously, then you ll want to avoid buying when the McClellan is trading at an elevated level. The NYSE Bullish Percent is another tool we use to time the market, albeit from a longer term time horizon. Like the McClellan, it does a great job of signaling overbought and oversold conditions, but unfortunately, does not reach these extremes too often. There are Bullish Percent indicators for individual sectors and groups, but the NYSE Bullish Percent applies to the broad market, and when the extremes are hit, it s a great tool to start looking for reversals in trend.
Like the McClellan, once this indicator reaches an overbought or oversold level, it s time to start looking for a trend reversal. In the Bullish Percent, those levels at 80 and 20, but as you can see, do not reach these extremes too often. The TA Swing indicator is another tool that we use to gauge market trends, and reversal signals in the market. It is a proprietary indicator we ve built to gauge market trends. It will not depict overbought and oversold conditions, but it will signal when a trend reversal has confirmed. Here is a quick look at the indicator below.
The indicator comes in the form of a color coded price graph. Looking at the 5 year weekly chart above, when the price graph is yellow, this signals a bullish market trend. When the price graph changes to red, this signals a bearish market trend. It is used primarily as a trending indicator, which is most useful to determine whether or not you are trading in the direction of the overall market. However, as a timing indicator, it is the reversal signals, or changing of color, that are most useful in this exercise. Take the most recent signal which illustrates the graph changing from red to yellow this week. As a timing indicator, on the print of the signal, this would be used to establish new long positions, or add to an existing equity position. In summary, these indicators are what we place most of our emphasis on when trading our Covered Call strategy from a market timing perspective. We will now move on to discuss how they can help the timing of the purchase of stock. Timing the Purchase of Stock The indicators we ve already discussed will help immensely in timing the market and the purchase of a stock simultaneously. At times, the market will trade in a high state of correlation, meaning the majority of stocks will rise and fall with the overall market. This makes it easy, as timing the market will usually coincide with the timing of a stock purchase.
If you have decided on a stock to purchase and are waiting for an entry point, you can simply wait for an oversold reading using the McClellan oscillator. This will work not only for your initial purchase, but will also work for any additions or subsequent purchases you make in addition to your existing position. You can also use the TA Swing indicator, and time your entry based on a change in market trend. As most stocks will rise in a new confirmed uptrend, or fall in a newly confirmed downtrend, this indicator will serve as a viable signal to the timing of a trade as well. It is important to note that this indicator can also be applied to the underlying stock, in order to generate trending signals to the stock you are looking to purchase. However, there are a few indicators we ll add to the list, to help insure the proper timing of a purchase. First off, it is important to note that the entry points we discuss on an ongoing basis are still relevant and valid for this strategy. For example, buy signals via point and figure chart, entry points off bullish trendlines, or any other buy signal generated by various technical indicators are still valid and can continue to be used in this strategy. Let s take ConocoPhillips as an example. As we ve determined by the TA Swing indicator, the recent signal on the weekly chart has been a bullish trend confirmation. Let s now look at ConocoPhillips and see how the chart looks. The chart looks good. Conoco has a bit of an uptrend to it, it s on a buy signal, and is only a few points away from its bullish trendline at $52.00. Going back to our earlier view of the McClellan, it is at an elevated level here in the short term. If I were a stickler for entry points, I could wait for the market to
come down a little, and then buy shares in Conoco, closer to its bullish trendline at $52. If I were to buy now at the last price, which was $55.05, prices are a little further from support, which could make this trade a little more difficult to manage as prices have obviously rallied here in the short term, a few points away from support. If the market was to pullback a little, based on the elevated reading in the McClellan, I could wait for prices to cool off a bit and buy them down, closer to support. If the TA Swing indicator held on to its buy signal, and Conoco was able to continue trading above support, I would target my entry at $52, with a stop beneath that if prices were to break down. It is important to combine market timing indicators along with stock timing indicators to determine action points in the underlying stock. In general, get comfortable with the idea of buying stock down, and never initiate a position by investing the full amount you plan to own at the time of purchase. Set a goal to scale into a stock. Using Conoco as an example, if I were able to get shares at $52, I would start with a quarter position, but no more than half of what I planned to own. If Conoco s share price continued to decrease, I can continue to average into this position, at lower prices. The Covered Call premiums that are sold along the way, as well as any dividend payments, will help to continually lower my basis in the trade, as well as generate monthly income. Timing the Sale of a Call The sale of the call in this strategy can get a little tricky, but once you develop a feel for the timing element, it becomes easier to pull off without the risk of getting called out, or limiting returns. Note: It is important to remember that the timing of the short call is important not only to insure that you are not called out of your stock position, but we also want call option premiums to increase as much as possible as the price of the underlying advances. When the underlying stock has stopped appreciating in price, that is when you want to sell premium. After all, that is when they ll be most expensive. Since we will be selling calls on a monthly, or possibly a weekly basis, we want to ultimately try to pick short term tops in trends. Take F5 Networks as an example. As the stock trends higher, each new relative high is what you would want to sell calls into.
You can see that each of these highs takes place every few weeks on average. As the stock price appreciates to each new high, the option premiums increase. As they do, this is where you ll want to sell them. Another proprietary indicator we use in the timing of selling calls is our multi-layered stochastic indicator. Using F5 Networks as an example, we ll use the short term signal line on the stochastic, which is green in color.
This short term signal line does a tremendous job at identifying these short term tops, which is part of the timing element we will be using in the sale of weekly and monthly options. Timing is important in this strategy, but it is not a life or death matter. Worst case scenario is that you might sell a call too early and the stock increases in value, causing you to get called out of your stock position. This is not the end of the world, as you ll likely be called away at a profit. This means you ll just have to start at the beginning again, or get back into the stock. Timing the Trade around Expiration Cycles The final piece to this chapter is to time the sale of a call, or the entry of a stock based on weekly or quarterly expiration. If you have no long term attachment to the stock, and don t mind being called away, that you might decide to sell calls on the day after your front month calls expire and new options are issued. This might also mean that on expiration Friday, if you are called out of a position, you might just hop back into the stock on the following Monday, while simultaneously selling calls.
There is nothing wrong with this approach, so long as you are not in danger of entering into overbought conditions, or are in a position where the stock has significant downside risk. The main reason we put so much emphasis on timing is to eliminate as much of the downside risk in the equity as possible. This practice will be very common in our Covered Call system, to sell weekly calls every Thursday on those stocks that offer them, but a little more judgment and finesse will go into selling options that are dated out a month. Remember, anything can happen over the life of the option, which is why we want to have the timing of the trade down to a science. In closing, this is a very critical step for those that would prefer to hold on to their stock position. However, it is also important that you keep in the back of your mind that having shares called away is all part of this approach. So long as you are called out at a profit, then we re ultimately reaching that goal of becoming consistently profitable in our trading approach.