TWO-STEPPING Part 3

WHAT HAPPENS WHEN YOUR COVERED CALL STOCK GOES DOWN IN VALUE?

This report is about protecting yourself from the downside price movement of a stock, especially in stocks used for covered call writing. I have four strategies to share with you, but before I do, it needs to be understood that writing covered calls has a set of rules, that once understood and used, will help you avoid problems and make more money. The first thing you need to understand is that this is a cash flow strategy. We are not buying a stock at $6 hoping it will go to $60. If it does so, great, but that is not why we do this. Think monthly income, even income several times a month (See TWO-STEPPING, Part 4, coming soon).

You must know the why and the how of doing covered calls. "The person who knows how will always have a job; the person who knows why will always be the boss." (Diane Ravitch) Once you understand the why, then you'll realize that you can make just as much money on your $6 stock if the stock goes to $4. But I'm getting ahead of myself.

FOUR PROTECTIVE STRATEGIES
1) The first strategy to protect yourself from a downdraft in a stock price is this: "An ounce of prevention is better than a pound of cure." I know it's cliche, but it's true. People get a little angry when I say this: "If you think a stock is going to go down, or back off, then don't buy it." I too get angry.
Do your homework. Is the company making money? Does it have a P/E and/or are the earnings growing? This demonstrates a solid picture. The options say a lot about the stock. They should be about 6% to 10% of the stock price. An $8 stock should have an $8 call for a month out around 8%, mas o menos.

The best way I've found to find a good stock is to check the support level. You do this simply by looking at a chart. I like 6 month charts, but you may want to look at one going back a year. Say the stock trades between $8 and $10. It's been doing so for about nine months. Once in awhile it goes below $8, but every time it hits $7.60 it bounces off that number. I call this hard support. You can look at soft support, say a comfortable range, but I like hard support or a price the stock does not go below.
You can use any charting service. Most are free. Check out yahoofinance.com; bigcharts.com; or stockcharts.com. Your brokerage firm probably has a free charting service. Charts are like a map. Use them as such. Sure, the stock can break down more. EPILOGUE DOES NOT MEAN PROLOGUE. If you can, go back and check the news when a stock changed price---up or down---by a 10% to 20% move. There is always a reason for movement. Check the market at hand, especially red-light periods (no-news) or green-light periods (news, as in quarterly news times).

Looking at charts will reveal a lot about your personality. Are you an optimist? Then your thoughts will go in that direction. Sometimes it pays to be a pessimist, or at least a skeptic when looking at charts and trying to project movements. I heard an old expression once: "I'd rather want what I don't have than have what I don't want."

2) The second protective strategy is to practice trade, or what I call paper-trade or simu-trade, as in simulation trade. Practice with pretend money first. On paper, buy the stock, then sell the option or put in an order to sell the option at a certain price (Limit order). Many online accounts have a practice trade section, some with real time, streaming quotes.

Can you imagine a rookie baseball player making it to the majors the first day out? A few do, but not many. They work their way up through the minor leagues, working on their skills. Day in and day out they grind it out, sometimes for years. One of my favorite admonitions (because I received it from a wise person and have had to be reminded of it many times) is this: "Everything you have learned to do and do well, you were hand-trained by someone else." You don't learn to drive a car by reading a driver's ed manual. You don't learn how to ski by watching a video. You need to get in the game, but practice first.

This is one reason why I like blogging. It's lets me teach and share my knowledge. You can learn from my experiences which have cost me dearly. "Perfect practice makes perfect." Paper trade each strategy at least ten times, of which six in a row must be profitable, before you ever use real money. This will help you avoid mistakes. Oh, and keep paper trading even when you've invested all your money. You may be waiting for the next deal, or for money to come in, but whatever, paper-trading helps you stay alert, in-the-know, and on-the-go. When the money comes in, you're ready to take action.

3) This third strategy will save you from losing a lot of money most of the time if your stock goes down. It's called a "stop-loss." You place a stop-loss order when you are afraid the stock will go down past the point you don't want it to go to. It costs nothing to place the order and you can change it anytime.

Back to our $6 stock. It looks solid here, but you fear it may go down some more. You place an order to sell the stock if it hits $5.50. If it moves down to that price the computer will trigger a sale. You're out of the stock and in three days the money will be back into your account. There may be a problem with stop-loss orders in writing covered calls. Remember the word covered means you own the stock. Well now, if you sell your stock, you don't own it anymore. In most accounts, the brokerage firm will buy back the option for you. They will not let you stay in an uncovered position, unless you have secured the right to do so. I won't comment much more on this part of this topic, suffice it to say, you should ask and get the right to write uncovered calls. Now, I didn't say to write uncovered calls, where you don't own the stock. To do so, creates a new batch of risks and concerns. Some people only write uncovered calls. Good for them, but for the average investor, it's not worth it. It is a very bearish strategy. Why do it then? You could stay in an uncovered position for a day or two, just before expiration, let's say.. Now the stock hits the $5.50, and you're out of the stock. There's little chance you'll get called out at $6. Why spend 5 or 10 cents, $50 or $100 to buy back the option on Thursday, the day before expiration? Use this right sparingly.

Also, today, with the speed of computers, you can place a hard order to sell a stock at a certain price, and you can set alerts at a different price, or have your broker do so. You place a hard order to sell the stock at $5.50, but you have an alert at $5.60, so you can look at the whole picture, before your order goes off. This way you can make a better decisions. I really like alerts. They help a lot.
Another problem with stop-loss orders is this: you can get picked off in a second. The stock takes a  brief dip, and your order goes off. You're out of the stock and the stock goes back up to $5.90 before the next commercial. You see, these market makers see all orders. They can drop down and pick you off before you know what happened. So set your order low enough to avoid this.
How do you choose the right price for your stop-loss order? I have found three ways. I disagree with the first way, but it's what everyone else teaches and writes about. I am also not fond of the second way.
          A)  Use a percentage you're happy with. Some say 10% of the stock price. Sorry, I don't like it.
               This is an easy way to think of it, but it just doesn't make much sense.
          B)  Use a dollar amount. Some use the amount they made off the option, so they'll break even.
               If they buy the stock for $6.00 and take in 60 cent for selling the option, they will subtract
               the 60 cents for the $6, setting the stop-loss at $5.40. I'm okay with this, as I think it shows
               some thinking and strategizing, but I think there is a better way.
          C)  Look at the charts. Find the support level, again what I call hard support. Now place the stop-
               loss order just below that. Yes, just below that. Say the chart speaks to you. The hard support
               looks like $5.20. It's only hit there twice in the last year. Now set the order at $5.10 or $5.00.
               This works best for me.
One more point on this topic. If you have a stock you like, and you feel it's weak, sell the in-the-money call. I.e.., you stock has gone from $6 to $5.20. You're not sure of the direction, but the whole market feels weak, so sell the $5 call, not the $6 call. When you do so, you're selling everything above $5. It's more cash into your account.

AUTHOR'S NOTE:
There is one other aspect to this. Some say it's a good strategy. I've never been able to see the need for it. I've never seen it work the way people think it will. They say to take some of the option premium you've made from selling the option and using it to buy a lower strike price put. A put goes up in value if the stock goes down. Okay, I get it. But like a call, everything has to happen in a quick and timely manner, or you will lose. Example: Sell the $6 call for 75 cents, or $750. Now use $150 of that to buy the $4 put, protecting the downside. I ask: Why spend the $150 as it will probably be wasted money. If you were to sell the $5 or the $6 put, it might be better, but it would more than likely cost you all of the $650 you took in. I don't get it. I suggest the other strategies.

4)  The fourth way is to quit being so pessimistic and look for an opportunity to make more money. I'll say it simply: You can make just as much money on a monthly basis with the stock at $6 as you did when the stock was at $8. I agree that no one wants to see their investment go down. In fact, many people bail out. That might be the right strategy if you've checked the news and other factors and think the stock may go down further.

Here's an example involving two of my friends. They participated in one of my tele-seminars and loved buying stocks and doing covered calls. They had purchased 1,000 shares of ELN for around $11 each, or $11,000 plus. Over the next year they made about $11,600 cash profits, or about 10% a month. Then the stock dropped to around $9. At first they were devastated. This down movement paralyzed them. They were stymied and did nothing for a few months, waiting for the stock to recover. I joined in their discussion and asked a question: "Why did you buy the stock? Was it to wait and hope it would go up to $20 or $100 a share, or was it to use as the asset, the base for covered call writing?" They answered that it was for generating monthly income. Back then I called it R.I.G. That stands for Repetitive Income Generator.

I had them look at the $8 calls and the $9 calls. The premiums were quite large. Oftentimes when a stock tanks the implied volatility goes up, fluffing up the options. They were still able to make $700 to $1,000 a month. To make the larger amount they had to double dip---work a little harder and make more.

I've said for years that one of the keys to wealth is to "grow out of your problems." As long as there are call options available, there is money to be made. So don't belly-ache, grow, increase---create your own stimulus package. And a quick note to all of you who have had stocks go down in price, and you're still holding them, FIGHT BACK. I call this a stock repair kit. It may take years to  wait for you stock to recover lost ground. You don't have to be a victim of this downturn. You can develop the skills and pound cash back into your account. R.I.G. to the rescue!

Also, one other consideration. Say you have a $10 stock that is now sitting at $6. Maybe selling it and finding a better covered call stock is the way to go. It's all just inventory. Re-deploy your money where it will do the most good. Think like a cash flow millionaire.
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