We have shown you an example of the use of the Strategist Scanner and Stock Sentiment services in our recent newsletter as of Sep, 29. We found 10 candidates for the Covered Call Write strategy in this newsletter, and now are going to check the performance of these hypothetical trades.

Stock Sentiment service enhancement

First, let us describe a new useful feature we have introduced in the Stock Sentiment service- thanks to rather numerous user requests. This is the "Sentiment in Brief" section, which allows grasping the market sentiment on a stock at a glance:

Fig. 1 "Sentiment in Brief" section of the Stock Sentiment service

This section is shown just under the Symbol field, and so is the first thing you'll see after entering the stock ticker. Basically, it counts a number of Buy, Sell and Hold signals, and then calculate two intuitively clear values - Bullish Rank and Volatile Rank. The first one shows the directional sentiment (how bullish it is), +100% being "absolutely" bullish, and -100% - "absolutely" bearish. The second one estimates the expected stock volatility (how violent its price will move), where +100% stands for "extremely volatile" and -100% for "motionless, sluggish". We will not enter into the details here as to the calculation method, as that is described fairly well in the online help (note the white "?" marks) and the Stock Sentiment User Guide. It is sufficient to say that these ranks are based on the summary of all the indicators shown in Stock Snapshot and Technical Analysis section of the service.

Checking the performance - how and what

Now, back to the horses. In the Sep. 29 newsletter, we found the following 10 candidates for a Covered Call Write strategy, using rather aggressive requirements of expected profit, downside protection and stock sentiment:

Tab.1 Candidates for Covered Call Write as of 09/29. All the names are traded on NASDAQ, except ELAN CORP. Option expiry is always November 2004

Now we are going to check how well these hypothetical trades performed, using the following (rather common in our newsletters) set of exit rules:

• we stop loss, if return becomes greater than -10% loss
• we take profit, if return exceeds +20%
• we are "forced" to take profit, if call option is exercised against us; in fact, this is a major hope of Covered Call writer, that the option will be exercised against his/her. We assume that counterparty decides to exercise if his/her return exceeds +20%. As we will see below, the exact figure of +20% does not matter much.

A couple of more remarks on how we are going to perform this backtesting:

• the trading signals were generated as of 09/27, so we use next day (09/28 close) prices for entering the position
• we assume that the option is sold at closing bid, and bought back at closing ask
• for buying stock, the closing mean is used, since bid/ask spread is negligibly small for our purposes here
• capital required for Covered Call Write is calculated as 50% of the underlying price minus option proceeds (using bid price)
• closing the position implies selling the stock and purchasing the Call back

Now let's check the results.

Checking the performance - the results

Four trades out of 10 would've been closed up to 10/15/04, according to our exit rules. The table below shows them, along with the exit date, reason for exiting and the worst / best / actually taken returns:

Tab.2 Performance of the closed trades

As it is seen, we "missed the point" with APPX and ELN, and had to take losses of 13.3% and 10.8% respectively. Both stocks declined rather sharply by 6-7% from close to close, triggering our stop loss. But with the other two stocks, JUPM and UTSI, we've been "happily exercised", getting the positive returns of 38.4% and 27.0%. The counterparty (call buyer) returns amounted to a figure of about +130% in both cases, so buying a naked call was not a bad idea at all! JUPM advanced by 16.5 % from close to close, while for UTSI the move of +4.3% in stock was sufficient to turn call buyer profit from 14% to 130% in one day.

The average return of these 4 trades, assuming equal dollar investment into all 4 stocks is 10.3% - that is roughly a half of our 20% target.

Now let's have a look at the remaining 6 trades; the table below shows the return if the position is closed on 10/15, and Bullish Rank for the stocks as of 10/15:

Tab.3 Performance of the other 6 trades, not closed as of 10/15/04

All the returns are positive (not bad), except for NABI:NASDAQ. Looking at the sentiment (Bullish Rank column), we see that trades on LRCX and NABI are better off to be closed, since underlying sentiment is no longer bullish. At the same time, it looks tempting to close Covered Call Write for RECN and RIMM, and engage into more aggressive bullish strategy, like a naked Call purchase.