Traders who are familiar with my style will know how partial I am to the Descending Wedge pattern. The Descending Wedge is considered to be a bearish reversal pattern and my experience is that this is one of the most reliable of the available charting patterns. Examples of recent Descending wedge patterns can be found through this link. The tech stock GOGO is one such stock I have been stalking of late and it made a minor trend line breakout recently that piqued my interest and had me initiate a new Covered Call trade.
GOGO weekly: the weekly chart below shows that the upper wedge trend line has been tested but that price action has pulled back, with recent market weakness due to expanded trade tariff news, to test the key $5 level.
GOGO weekly Ichimoku Cloud: Ideally, I would like to see a break above the weekly Ichimoku Cloud and an uptick with trading volume before initiating a trade:
Given the low cost of entry for the stock and the decent Option premiums I was prepared to enter a trade on GOGO despite seeing only one bullish signal on my charts.
I could have entered a trade on GOGO in either of these ways:
- buying the stock
- selling a naked Put Option
- selling a Covered Call
- buying a Call Option
My goal in this trade was to try and participate on any potential bullish gain for GOGO and so, with this in mind, I opted for selling an OTM Covered Call. By doing so I was able to obtain the stock; which was something I was keen to do. I was also able to gain some Premium from selling the Call Option which helped to offset the cost of the stock and lower my break-even for GOGO.
I did not want to sell a Naked Put in this instance in case there was any bullish continuation for GOGO. A naked Put would earn me some Premium but would not enable me to enjoy and gains if the stock was to appreciate in value. I did not want to buy a Call option in case price action chopped sideways for a period before any potential continuation; something I do see on occasion with breakouts from descending wedge patterns. I also did not want to simply buy the stock as there is always uncertainty with any trade. Thus, by selling a Call on the owned stock I was able to reduce my break-even cost for the trade.
I opted for selling an OTM Call option to the value of $6. This means that I am obliged to sell my stock for $6 if GOGO is equal to or above $6 at option expiry. However, if there is any bullish continuation for GOGO beyond $6 by June 21 then I will also receive some extra payment; that being the difference between what I paid for the stock and the $6 price when it is called away from me. Should GOGO close above $6 on June 21st and the stock is called away from me: then I will enter a new Covered Call trade to catch movement on the way up to the identified first target of $20.
The following calculations give a breakdown of the two scenarios potential for this trade: one for if GOGO is below $6 by June 21 and one for if GOGO is equal to or above $6 by June 21.
Stock Bought: GOGO: bought for $5.80
Target: $20 being near the weekly chart's 50% Fibonacci level followed by $25 being near the 61.8% level.
Call Option Sold: May 21st: $6 June 21 Call = $0.30 option premium
Days to Expiry: 32 days
Calculations:
Scenario 1: GOGO < $6 at June 21
Return = ($0.30 Call premium / $5.80 stock cost) x 100%
= 5.17% for 32 days.
Annual Return = 5.17% x (365 / 32)
= 58.97% annualized.
New B/E on stock = $5.80 - $0.30 = $5.50
Scenario 2: GOGO > or = $6 at June 21
Note: I would gain $0.20 with stock going from $5.80 to the $6 level.
Return = ($0.30 premium + $0.20 gain / $5.80 ) x 100%
= 8.62% for 32 days.
Annual Return = 98.32 % annualized.
There is always the chance that GOGO will fall well below my break-even cost of $5.50 by June 21 as well and, thus, I will have lost some of my capital. If so, I will sell further Call options for the following month at a lower strike price and this will further lower my break-even. This will require some monitoring and potential rolling of Options as I do not want to be exercised at a level below my break-even. Keep in mind here however, I was prepared to buy the stock outright and, so, any fall in price would have incurred capital loss. By selling Call options in this manner I am able to lower my break-even and offset some of the losses should GOGO collapse in price.
(NB: IB Commission were excluded in the worked example simply for the ease of explaining the trade. However, the commissions on the stock trade was $1.50 and the Option trade was $3).