How To Pick Stocks Using Technical Analysis

An important element of covered call writing is technical analysis, a review of the chart and chart indicators. Those who write calls from a more technical perspective often do not care as much about the fundamentals. However, while charting experience and skill can add a lot to covered call writing, it is not primarily a technical endeavor. Technical analysis will never be 100% correct; if you are right 60% of the time, you are doing quite well. This is why my covered call writing methods are based on fundamentals.

There are covered writers who are seasoned technicians, who look for a stock in a desirable trend or chart pattern, perhaps in tandem with the industry trend, and then write the stock if signals are green. The technical approach can be very profitable, but it rewards good charting skills and punishes poor ones! The conservative call writer looks for great, stable stocks that simply exhibit acceptable charts, which is a truly significant difference.

An interesting question is which comes first: technicals or fundamentals? If I am unfamiliar with the stock, I look first at the chart. If the chart is negative, then I usually don’t look further. The reason is that, while one can indeed pull good income from a falling stock, the price decline impairs the stock’s value, should the writer need or want to sell it. And if IV is only temporarily spiking on a normally low-volatility stock, we risk being stuck in a fallen stock only to see the high call premium dry up. One would rationally write the falling stock only if it is a portfolio keeper, the writer is stuck in the stock already and intends to hold and write it through a down price cycle, or the Collar Trade strategy is used.

The Chart Setup

There are many charting platforms and there are many choices in how to configure charts, such as candlestick or bar charts, the time period viewed, colors and indicators to be added, among others. You should choose the configuration that you find easiest to interpret. Charts usually are set up with the daily period as the base frequency, in which each bar or candlestick represents one day’s activity. Charts can be changed to weekly, monthly or intra-day periods such as an hour; even as short a period as one minute.

Never forget to use the weekly chart to confirm the stock’s longer term direction. A stock that appears acceptable on a daily could in fact be failing, approaching resistance of making some other negative chart formation, viewed on a weekly basis.

• DAILY – most covered writers begin with the daily chart, showing six to twelve months of activity, to give a good picture of recent price movement.
• WEEKLY – once a daily chart has been examined, look at the stock on the weekly chart to get an idea of the longer-term trend or range.
• HOURLY – for short-term trades of 10 days or less, some writers are more influenced by the 1-hour chart, in which every bar represents an hour’s price activity.
• VOLUME – the chart should be set up to show the volume histogram.
• INDICATORS – add any oscillators or other indicators desired.   
• Institutional investors may even care about yoy trends  

Volume

There is an old saying: it don’t mean a thing if it ain’t got that swing. This applies to the stock’s volume. The volume histogram shows the trading volume in the form of a vertical bar corresponding to each bar on the price chart. A chart without volume is like a football player without a helmet.

A price advance or decline should happen on higher-than-normal volume. When an advance occurs on normal or lower volume, it is said to be a bearish divergence, because it is not happening on greater buying. Similarly, when a decline occurs on normal or lower volume, it is said to be a bullish divergence, since it is not caused by higher selling. The stronger the advance or decline, the more volume should be driving it. Though over-simplified, that is volume interpretation in a nutshell.

Support & Resistance

Support is a price level to which a stock has sold off, and buying has over-powered selling. A stock that has found support may rebound or may trade in a new range at the lower level for a while. But resistance is the opposite: the price level to which a stock has risen and stalled because selling has over-powered buying. When a stock is trading in a range (so-called rolling or channeling stocks), the upper and lower bounds of the range are resistance and support, respectively. The careful call writer carefully notes the major support and resistance levels.

Remember that everyone sees the same price action on charts that you do. Traders tend to take profits at or close to resistance levels, on the presumption that price will fail there. Similarly, they tend to buy at support in expectation of a price rebound. A stock approaching a resistance level is worrisome because of the probability it will stall out there and fall.

Support and resistance are hard to gauge when the stock is approaching them. Oftentimes, stocks will spend multiple trading sessions at a support or resistance level, which is known as testing those levels. For this reason, the odds for a writer or investor are much better after support has successfully been tested and a price rebound is occurring, all on volume. Not all tests involve heavy volume or repeated sessions at the support or resistance level, though volume seals the deal. By contrast, one should not buy a stock at or approaching resistance unless – and until – the test of resistance is successful and several closes have occurred at higher prices on increasing volume.

There are minor and major support and resistance levels. The more times a stock has found support or failed at resistance (and the greater the volume on each test), the stronger the level is said to be. Only minor reliance can be placed upon a minor support level, but I treat all but the most minor resistance levels as ceilings.

When a covered call writer enters a trade that is above a major support level, the odds generally are good that the stock will find support there and recover. But the farther down support appears, the farther the stock must fall before we find out whether the stock will hold support. In this vein, be aware that moving averages and trend lines can act as support levels. This is because traders are aware of this and have a tendency to buy or sell at moving averages and trend lines, just as they do at obvious support and resistance levels measured purely by price action.

• An ideal write can be made after an otherwise acceptable stock has just successfully tested major support and resumes an uptrend.
• Beware of stocks declining to support, whether in a trading range or not; better to write them after a successful test.
• Be especially careful on price spikes, which may have outrun any reliable support level. The danger is that price will reverse sharply, whipsawing those who bought the spike.
• Do not write stocks at or approaching a significant resistance level, since the odds of a pullback are too great.
• Remember to check support and resistance levels on a weekly chart, also.

Moving Averages (MA)

A moving average is a line on a chart laid over the price action that shows the stock’s average price over the MA’s period. Thus a 50-day MA shows the average price over the prior 50 days. The next trading session, the latest price will be added in and the earliest price deleted from the calculation. Moving averages smooth out the price action and allow us to compare the stock’s price movement to the average. A stock can be at, above or below the moving average line.

A crossover occurs when a shorter-period MA breaks above or below a longer-period one; for example, if the 14-MA breaks above the 50 MA, that is a positive crossover. If it instead broke below the 50-MA, that would be a negative crossover.

Commonly used MAs are the 14, 20, 50, 100 and 200 periods, although this is an intensely personal choice. I often refer to a moving average as “reactive” if it is one with which the stock tends to commonly interact. It varies, because different stocks react with different MA’s. Also, a moving average’s usefulness can vary depending on where the stock and market happen to be. For example, in a bull market most stocks showing strength will be well above the 200-MA, thus it may be too far away from the price action of healthy stocks to be useful. Even in a bull market, though, a stock that has successfully tested the 200-MA or has just broken conclusively above it is considered to show strength; but if a test of the 200-MA is in progress, one would wait for a successful resolution to the test! A stock that is well above the 200-MA might be more reactive with the 100-MA, for instance. Note that for some stocks, no moving average is reactive.

For the covered writer looking to write over the short-term, the 50-MA has the most utility. If the write is a longer one (e.g., writing a LEAPS call), however, then one might be well advised to consult a moving average with a longer period. For covered writing I favor the 14-, 50- and 200-day averages, though sometimes the 100-day, depending on reactivity. They are easily changed on each stock, and this sometimes is necessary, since different stocks can interact with different averages; some react regularly with none. Changing the MA from the 50- to the 40-day average, for example, can bring the stock’s interaction with the MA into much better focus.

• Acceptable: the stock is ranging narrowly and at or above the 50-MA, or has recently broken above the 50-MA from below and shows multiple closes above the MA.
• Best: the stock is in an uptrend, is above the 50-MA and is at/above the 14-MA. If the stock is in an up-leg of a trading range, plan to exit before price hits resistance.
• Spikes: However, if a stock has spiked high above the 50-MA and 14-MA, be cautious about writing it, because it is likely due to pullback; flat or falling volume exacerbates the danger.
• +Crossover: A positive moving average crossover (e.g., 14-MA is crossing above the 50-MA) is a sign of price strength; even more so if volume increased on the move.
• Support Tested: It is positive that a stock has recently tested the 50-MA (or other reactive MA) or the trend line and has rebounded.
• Support Broken: It is negative that a stock that is under the 50-MA. It is even more negative if it recently has broken under the 50-MA or other reactive MA, which acts reliably as support; even more so if on increased volume.
• -Crossovers: Avoid negative moving average crossovers: e.g., the 14-MA is crossing below 50-MA, or the 50-MA is crossing below the 200-MA.

Where the 50-MA is not reactive with the stock, the above guidelines should instead be taken to refer to the most reactive short-term moving average found. Where the market is turning negative or has been flat for a while, the 100 or 200 periods will be useful as barometers of price health.

Trend and Chart Patterns

The writer’s goal is first to assess whether the stock is in a trend or trading range. An uptrending stock makes higher highs and higher lows; a downtrending stock makes lower highs and lower lows. Anything else is considered to be in a trading range. More information on charting is included further on in the Technical Analysis chapter.

For straight covered call trades, the ideal setup is a good, conservative stock in a good uptrend. A stock in a trading range can be acceptable also, although if the trading range is large, it is ideally written after the stock has found support and is again advancing. When possible, buy strength. We never want a stock that is weaker than the overall market. Occasionally one finds a chart that defies characterization, and these are better left alone, particularly when the stock is a volatile one.

It is helpful to draw trend lines to determine the actual trend. The trend line allows a more precise discernment of how price is moving in the trend. It is important, also, to see how price interacts with the trend line – in particular, whether the trend line reliably acts as support or resistance.

Integrating the Chart Information

That is a lot of information to consider, right? No, it just seems like it. With practice you’ll find that you take it in at a glance. For example, you will automatically compare volume to price movements. But you do have to get your arms around the information. Here is a run-through of the process I use.

My charting process is to first view the stock on a daily chart showing six to nine months of price activity. If it is acceptable, I view the stock on a weekly chart for a sense of the major (longer-term) trend. When the trade will be of 10 days’ duration or less, I consult a 60-minute chart, in which every price bar represents one hour; the weekly chart is much less useful in this case, but I still view the weekly because I might wind up in the trade longer then anticipated and want the longer-term picture. These are some very general guidelines for using chart periods that have proven helpful:

• The ideal setup is strength on both daily and weekly charts.
• If a good company is showing some weakness on a daily chart but strength on a weekly chart, I will often select it.
• I may pass on a trade when the reverse is true: a stock that looks strong on a daily is close to failing or a resistance level on the weekly. Even with a strong stock, why buy weakness?
• The 1-hour chart is used to find strength for trades of ten days or less, since a short trade duration is no benefit if the stock is weakening over the trade’s expected duration. For such quick trades, I also look for strength or neutrality in the daily chart.

I pay particular attention to volume. Some stocks will show nice advances or even lengthy uptrends with no meaningful volume, but these are not my favorites; I like stocks that follow the rules, because volume changes then carry some weight. Important: note whether advances, declines and swing highs and lows occur on greater-than-normal volume.

NOTE: If your charting program allows it, overlay a moving average on the volume histogram itself (Yahoo’s new free charts allow this). Set the moving average period to three or four days, so that volume spikes will show very clearly.

Remember, too, that a trend line can be drawn on the volume histogram. That is, in addition to noting volume on swing highs and lows, note whether trending price movements are matched by a trend in volume. For example, if price is trending up but volume down, this is bearish because the trend is happening on falling volume. This does not mean the stock will soon fall, but it well might. And if the stock is trending down, falling volume is bullish, since it indicates the decline is weak. These bits of wisdom apply with the most force to the more liquid stocks, not the low-volume crowd. Note that when the market has corrected and is advancing, virtually all stocks will advance on light or even falling volume as the typical U.S. bullish bias reasserts itself.

I overlay the 14-, 50- and 200-day moving averages upon the price action. If the 200-MA is far from the action, I might use the 100-MA. You may find multiple moving averages confusing, but use different colors (consistently) for them and you will become used to them. The interplay of price with all three averages can be important, as well as their interplay with each other. I look to see, first, how the stock reacts with the 50 and longer-period averages.

I may experiment with different averages, but what is important initially is to determine whether the moving averages have any predictive power as to the stock. Does a particular average act as support or resistance? For example, the stock might have broken below the 50-MA but found decisive support at the 100-MA, which could indicate a technically strong short-term write.

I also look for positive or negative crossovers. Remember that there can be multiple MA crossovers. For example, a weakening stock may show the 14-MA crossing below the 50-MA, then the 50-MA in turn crossing below the 100- or 200-MA. The 14-day average is not important in and of itself, but it can provide an early signal for strength (crossing above) or weakness (crossing below) as it crosses the 50-MA.

I am not a heavy user of oscillators, but I use a few. C0nsulting too many of them leads to paralysis by analysis, since some indicators will conflict with others. One easy trick is to look at several indicators for the stock and note which ones seem to have predictive power. While this can change for a stock over time, it is unlikely that it changed today. For trending stocks, I use the MACD (moving average convergence-divergence), which is a blend of moving averages; it is too slow to use for a ranging or volatile stock, however. For ranging or volatile stocks I use the RSI (Relative Strength Index), which indicates whether a stock is overbought, oversold or in the middle; but it is not generally helpful with trending stocks.

I sometimes consult money-flow indicators, such as the On Balance Volume and the Chaiken Money Flow indicators. They broadly measure whether money is flowing into or out of a stock. On an uptrend, the line should be rising, and if it is flat this indicates that the move is not very robust.

I do not use envelopes such as the Bollinger Bands, though for some stocks they can be quite predictive. Excellent commentary and instruction on using these and many other indicators can be found at master technician John Murphy’s website: www.stockcharts.com.

What am I looking to determine primarily is the stock’s trend and the strength of the trend, both short- and medium-term. If the stock is ranging, I want to be clear on the range boundaries. I note support and resistance levels, both minor and major, as well as the extent to which the moving averages and trend lines provide support and resistance. I want to see whether the stock makes it movements on volume or not, particularly recent movement. I am looking for a quality chart, to be sure; a positive chart. But I am also examining whether the moving averages, support and resistance levels, volume and any indicators have predictive power. I also want to determine whether the stock normally exhibits bullish and bearish divergences. If the chart seems to follow no rules, I would consider the stock only if it is very large and robust, one that I would be willing to own and continue writing.

Do not set up rigid, impossible tests that few stocks can pass. Doing so will unduly restrict the field of trade candidates.

Some covered call coaching teach that stocks should only be written in the bottom of a trading range, or not while in the top 25% of the price action in the preceding twelve months. I have found that these artificial parameters work sometimes, but many times not; in my experience the exceptions tend to swallow the rules. For one thing, stocks in a bull market should be making new highs or reaching old highs; this is not a negative. I don’t believe that a valid case can be made, statistically or otherwise, that stocks showing less strength than the market are somehow better or more conservative writes.

Some believe that we should look only for ranging stocks and write stocks approaching the range bottom or which have already bottomed. This can work quite well. Books typically depict stock trading ranges as perfect little sine waves, like rolling swells on a calm ocean. But most ranges are not so smooth or predictable, and many are extremely irregular. For one thing, there will be internal support and resistance levels within most ranges, particularly wide ones. For another, a trading range is a congestion pattern in technician terms, meaning that a stock ranges on its way up, or down to someplace else; sooner or later the stock will break out of the range, whether to the upside or downside. Thus it is difficult to make the case that writing stocks at range bottoms is “safer.” It is only safer while the trading range persists. And it makes only makes sense in my view to write a range bottom after support has been tested successfully: only then is it a “bottom.”

Relative Strength (RS)

Relative strength (not the Welles Wilder Relative Strength Index) is a measure of a stock’s price performance compared to a benchmark index, usually the S&P 500, Russell 2000 or Nasdaq Composite indices. Relative strength really is a measure of money flowing into or out of a stock. A stock price outperforming its index will have a RS score. Yet relative strength is not a quality measure, only a comparative measure. High relative strength in and of itself therefore does not qualify a stock as a conservative covered write. A low-quality, faddish stock could show a very high RS. In fact, high RS and low quality (mediocre or no earnings, etc.), or a combination of high RS and a P/E that is much higher than the company’s industry is a warning sign.

Worst of all is this combination:

• High relative strength;
• Low quality company or highly overvalued stock (both is worse); and
• Relative strength has begun to decline – potentially poised to break down;

Other Patterns

I primarily work with the price chart, volume, trends and trend lines, support and resistance, moving averages and a few key oscillators. There are many chart patterns, and all covered call writers are urged to become conversant with them. Only experience writing covered calls will give the writer confidence to exploit chart nuances. The less-practiced writer is urged to stay close to the conservative precepts in these articles. They work, and there will be a time to spread those technical wings with experience.

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The author has no position in any of the stocks mentioned. Financhill has a disclosure policy. This post may contain affiliate links or links from our sponsors.