The Sandisk (SNDK) daily chart (Figure 1) clearly depicts the simultaneous breakouts from both the 55-day upper price channel (blue line) and the well-proportioned inverse head-and-shoulders (H&S) pattern. As far as chart patterns go, this one is definitely in the bullish category…and then some.
SNDK also happens to be leading the entire Standard & Poor's 500 in terms of 13-week (one calendar quarter) relative strength, meaning that there is a good possibility of meaningful follow through as even more institutional money finds its way into this tech giant's stock. In the lower portion of the chart, note the bullish trends of both the positive volume index (PVI) and the negative volume index (NVI); when both are rising and in strong trending mode, the stock in question is likely a very good candidate for covered call writing, especially when it's also a relative strength leader sporting such a powerful breakout move.
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SNDK, DAILY. Any time a strong relative strength stock has a major bullish breakout, verify the state of the volume trends in the stock. In this case, both the positive and negative volume indexes are in agreement that the most likely pathway for this stock is higher.
There are several keys to successful covered call writing, including these:
1) The existence of a strong trend and/or strong relative strength
2) Attractive option premiums and strike prices
3) Logical places (preferably strong chart support) to set an initial stop-loss
According to these guidelines, SNDK is offering all of these minimum requirements, making it a suitable candidate for a June 2010 in-the-money covered (ITM) call. Here's the one I have in mind at the time of this writing (these prices and profit/loss numbers will change—use current pricing of both the stock and option to update these numbers):
Buy 100 shares of SNDK stock
Sell one June $44 call option
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Net debit: $42.50 or less ($4,250 before commissions)
Once filled on both positions, the best starting point for a stop-loss exit is the May 25, 2010 low of $40.06. Even if this trade goes completely against you on the first day, your loss will only be about $339 (roughly 8% of the total cash outlay), and given the fact that is a remote possibility now (because of the strength and breakout force of the stock), this stop-loss will help give the stock plenty of room to back and fill between now and June options expiration, only 20 days from today. Should the stock follow through with the H&S breakout, gradually move the stop higher, perhaps using a three- or four-bar trailing stop of the daily lows once the stock (hopefully) gets above $50 per share. Once you're in the trade and trailing the move, all you really need to do is wait until June option expiry (see Figure 2). If the stock closes at $44.01 or higher at expiry, the stock leaves your account and you keep all of the option premiums on the short $44 call, giving you a net profit of about $145 before commissions. That equates into an annualized return of better than 50%, not bad for a three-week allocation of cash and time.
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SNDK EXPIRY.
Should SNDK shares be called away at June option expiry, sellers of the June $44 call can expect to earn better than 50% on an annualized basis.
The broad markets are on a collision course with very strong resistance levels (the Russell 2000 has already met its nominal swing target price coming out of the recent low), so expect some price turbulence in SNDK once these levels are hit in the next few sessions. Thursday's volume and range was fairly impressive, however, so SNDK should have plenty of force pushing it higher until the stock starts complaining of altitude sickness. If you put this trade on, be sure to actively manage the initial and trailing stops, seeking to progressively reduce and then eliminate all trade risk.
