By Chris Ebert
The following trade has profited week after week, every week except four of the past 192 weeks. That’s nearly four years of virtually continuous weekly gains; and of those four losses – none were big enough to be a concern or a danger to anyone using the strategy properly.
Sell a Covered Call option on $SPY (NYSEARCA:SPY) using an at-the-money strike price and an expiration date as near as practical to being exactly sixteen weeks away, then hold it until expiration day. That’s it! That’s all there is to the trade.
Obviously, such a strategy can’t work all the time. But, it works wonderfully well in Bull-markets and even in choppy sideways range-bound markets. The only time it fails is in a Bear market. In fact, most weeks it returns the maximum potential profit that is possible for such a trade.
Recently, however, even though profits have continued each week, those profits have been less than the maximum on several occasions. It’s an important development because failure to attain the maximum profit can sometimes be an indication that widespread distribution is taking place in the stock market.
The Implications of Declining Covered Call Profits
Distribution is a term used in the stock market to describe the process of selling large blocks of stock without overwhelming the market. Ordinarily, if large numbers of shares are offered for sale all at once, there are not enough bids (at the current stock price) offering to buy those shares.
To sell a large block of shares all at once requires accepting all of the bids at the current share price plus some bids that are below that price. When the sale is complete, the final trade is often at a price well below the price at which the stock was trading earlier. Selling a large quantity of stock too fast can lower the share price considerably. Distribution seeks to avoid the drop in price by parceling out the sale of large blocks into smaller blocks that are more easily absorbed.
Done successfully, the process of distribution allows the sale of large quantities of stock to occur over an extended period – days, weeks, or even months – without requiring the acceptance of an excessive number of low bids. Thus the stock price may not decline at all, even though a large investor or large institution is getting rid of all its shares. In some cases the price may actually continue to rise.
“The process of distribution is much like pouring water on a campfire. Pour too slowly and the fire may burn itself out before the water is gone. Pour too quickly and the water may extinguish the fire. But pour at an optimal rate and it may be possible to use all the water while the fire continues to burn.”
It is important for a trader to recognize distribution because of the motives behind it. Large investors and institutions are often privy to information not available to the public. Therefore, such stockholders tend to sell their shares when they know something the public does not – that the stock price is likely going to decline in the near future.
Knowing that stock prices are on the way down does not necessarily require illegally obtained insider information. Some institutions are so large that they have the ability to move stock prices just by their actions in the market. Just as distribution seeks to prevent unwanted declines in stock prices, a single large-enough entity can often intentionally drive stock prices down simply by dumping a sufficient number of shares for sale on the market all at once.
It makes sense that if large institutions were planning to drive stock prices down sometime in the near future, that they would employ a period of distribution, prior to the anticipated decline, in order to collect the best prices on the largest blocks of stock they intend to sell. Once they have sold most of their stock in an orderly fashion – through distribution – they can then dump the remaining blocks of stock for sale on the market all at once and drive stock prices much, much lower.
Recognizing Distribution in the Stock Market
So, how does the individual retail trader recognize distribution in the (more…)