(AMZN) Looks Ripe for Covered Call Strategy

10/21/2010 12:01 am EST

Focus: OPTIONS (AMZN) shares have done pretty well since putting in a major low last summer, rising more than $58 in less than four months. Right now, the shares appear to be poised for a continuation breakout or a period of consolidation, but not for an outright decline.

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For breakout traders, this trade set-up says "Let's go." Money flow is supportive of further gains, the trend lines have been ramping higher, the stock has outrageously high relative strength versus the Standard & Poor's 500 (.SPX), and the recent break higher comes with a wide range, even as the Fibonacci 127% extension ratio has been exceeded. In addition, the Rahul Mohindar Oscillator (RMO) trading system in MetaStock 11 has also issued a fresh RMO swing buy signal. See Figure 1.

Aggressive traders might be comfortable taking a straight long breakout entry here, while those less sure of an immediate rise might prefer to go the covered call route. Selling a $160 November call for every 100 shares of AMZN provides a good mix of premiums and staying power.

So you can take the trade…or not. Maybe AMZN will surge higher and you can grab another $5 or even $10 out of it without too much trouble. Or maybe it will chop around near the $150-$165 area for several weeks, deciding to further digest the massive gains made since July.

Adding to the confusion is the possibility of a cup-and-handle formation, one that may be about halfway formed (if at all). So instead of taking this breakout right away or waiting for a cup-and-handle that may never even fully form, why not just avoid discretionary trader gridlock and buy a covered call instead?

With less than 30 days until November option expiration, consider selling a $160 strike call option for every 100 shares of AMZN you wish to acquire. You can sell one for about $11 ($1,100 in cash to your margin account right up front), and the sale will give you a nice cushion if AMZN decides to delay a north-side breakout for a few weeks, just carving out an extended consolidation instead.

With the stock near $163 now, that $11 in cash for the short call brings your effective break-even price down toward $152, which also happens to be the lower range of the recent consolidation.

To give AMZN the full benefit of the doubt, why not just set an exit point on a daily close below $150, at which point you close out the whole trade and walk away with a minor loss? If the stock finally follows through on a break higher, give the stock plenty of room to back and fill so you don't get shaken out of the trade prematurely.

Covered call trades can be a wise choice when you're reasonably sure that a stock is destined for higher valuations, but the timing of the anticipated event is a bit more uncertain. This could be one of those times to employ such a stock/option strategy.

By Don Pendergast of
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