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Every once in a while, when using our covered call writing strategy a stock will gap up or down. A gap is a break between prices on a chart that occurs when the price of a stock makes a sharp move up or down with no trading occurring in between. Gaps can be created by factors such as regular buying or selling pressure, earnings announcements, and changes in an analyst’s outlook or any other type of news release. Here is a chart of Blue Coat Systems (NASDAQ:BCSI) which gapped down after an earnings report disappointed:

BCSI gaps down

From $29 per share this stock gapped down to $22 per share. Now for those Blue Collar Investors who follow my system you would not have been hurt by this precipitous drop because we avoid earnings reports for this very reason. However, a stock can gap down for some of the other reasons just mentioned. If there are many more sellers than buyers, a stock will gap down. A stock gaps in price when a blank space is left on the chart where no trading occurred. A gap up is when the current bar’s low is above the previous day’s high. A gap down is when the current bar’s high is below the previous day’s low. Stock gaps occur as a result of excessive buy or sell orders which forces prices either up or down.

How to manage a stock that has gapped down:

When a stock gaps down, human nature is such that you want to get your money back with this same equity. In this way, it will no longer be perceived as a loss. As a result, many investors will not unwind their position and just ride it to wherever it goes. This approach is misguided in some instances. Think back to stocks like Enron, Tyco, WorldCom, Citi, Bear Stearns, Lehman and many others. Holding positions in these companies spelled disaster even though these corporations were considered pillars of our economy at one time. Circumstances change and so we must be willing to change our perspectives as well. When a stock drops from $29 to $22 as it did in the figure above, we now have $2200 in cash per contract. We no longer have $2900 per contract. That was yesterday, not today. The question becomes “where do we want this cash to be placed to give us the best chance for a successful investment?’ It may or may not be with this same security.

So step one is to determine what caused the gap down. We must check the news to see what precipitated this unexpected turn of events. If it is a serious matter like corporate fraud, a key member of the Board of Directors leaving the company, the loss of a patent, the FDA disapproving a new drug, new legislation that negatively impacts that company or other events that dramatically alter the prospects for that company, it is time to hand that cash over to a new financial warrior. If, on the other hand, it dropped in price due to a less serious matter like a single analyst downgrade or guidance being amended slightly and a market over-reaction followed, we may opt to stay with the same equity.

Let me give you an analogy for those of you familiar with casino blackjack. In this hypothetical you hold a “15” and your prospects look bleak. This is analogous to the stock after it has gapped down. The dealer's hand represents the circumstances that will dictate how to manage the gap-down. Now do you stay with the “15” or do you make a change? Well that depends on the cause of the event or the dealers hand. If the dealer has a “5”, the event was not a serious one and the corporation remains a great opportunity in your eyes. Therefore you hold your position, as there is a good chance the dealer will “go bust” or go over “21” with his next card. Your investment outlook by holding your position looks positive. If, however, the dealer is sitting with a “10”, the cause of the gap down was a serious blow to the stock and holding would be a poor decision as the dealer has great prospects of having a “20” and destroy your prospects of a successful investment. Therefore, we must change financial soldiers and take another card. The point here is that given the same hand but different conditions, we must make different decisions. In much the same way, once we determine the cause of the gap down, we must have the non-emotional flexibility to make a change if that approach is indicated.

You decide to keep the stock:

If your decision is that the cause of the gap-down was not serious and you still have a great opportunity with the same equity, we first buy back the option. Since the price has declined dramatically, the price of the option has also done so. If we are mid-contract or earlier, I will wait for a bounce back and resell the same strike to "hit a double". If the stock is slow to recover, we can roll down to a lower strike price that is still above the current market value. In the example above, selling the $22.50 strike will generate income to help offset the share value depreciation. If we are correct and the stock continues to recover, we can nurture this security up by selling out-of-the-money strikes.

When we decide to hold a stock that has gapped down, we are employing a strategy I have named technical nullification. In a manner similar to jury nullification, where a jury ignores the facts and opts for an atypical conclusion, we will be ignoring the technicals like the chart pattern and accumulation/distribution (A/D) and others and still hold this equity. Let’s look at a chart of BCSI three weeks after the gap-down where it is consolidating and forming a base from which it may head back north:


BCSI after gap-down

Notice how BCSI, after the huge gap-down (red arrow), has been trading sideways between $22 and $23.50. Using technical nullification and feeling the prospects of a return to previous pricing will lead us to selling out-of-the-money calls, in this case the $25 strike. The option chain shows a return of near 2% for the next month out-of-the-money $25 call:


BCSI- option chain

In addition to looking at the short term technicals of the stock after the gap down, we should also compare its price performance to that of the broad market. If it is consolidating (trading sideways) but well-underperforming the general market, I would view that as a negative and consider selling the stock. In the chart below, we see however, that BCSI has equaled the recent price performance of the S&P 500, re-enforcing the confidence we may have in this equity.

You decide to sell the stock:

If you feel that the cause of the gap down was a longer term issue, buy back the option and sell the stock. We then utilize the cash generated from this sale to enter a new covered call position.

Conclusion: After a stock gaps down as a result of an unusual event we have the choices of either unwinding our position or keeping the stock. We base our decision on the reason for the gap-down. Should we consider keeping the stock, it will require technical nullification, monitoring the technical pattern of the stock after the gap-down and comparing the price action to that of the broad market.

Disclosure:

I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Source: Covered Call Writing: Managing Stocks That Have Gapped Down