A Covered Call on a Gold Stock? Really?

Only true mining stock die-hards would have noticed, but the gold stocks have actually been building strength. I don't know if Friday's surge in the price of Gold is the start of a longer-term rally, or if will quickly fizzle out. And the fundamentals, on just about any gold stock you pick, are just plain lousy.

But if you have researched stocks and found that the best time to buy a sector is when everyone else hates it, or as the news goes from bad to less-bad, then you might be interested in this particular setup. And I will go one step further and use seasonal analysis to get a feel for the risk, and reward, involved.

Barrick Gold Corp (ABX), like all the other gold stocks, has been hit hard by the falling price of gold. The dividend has decreased 90%, quarterly sales have dropped 21% in 2 years, and so forth. But one thing stands out – the volume pattern on the daily chart shows clear, steady accumulation going on in this stock. The Up/Down Volume Ratio, at 1.4, confirms this.

ABX appears ready to break above 4-month resistance around the 8.5 level. As the dust was settling in September 2008, I noticed the first stocks that rebounded were the gold stocks, and I did very well trading covered calls. So on a whim I checked out ABX covered calls, especially on the weeklies.

ABX closed at 8.09. But it seems very likely to hit at least 8.5, if not higher, within the next few weeks. The ABX December 26th expiration weekly 8.5 calls, which will last-trade on Dec 24th, are currently .19 Bid, .21 Ask. So let's say that on Monday morning you buy 1000 shares of ABX at 8.09, and sell 10 Dec-week4  8.5 calls at 0.20. The stock would cost $8,090, but you would get back $200 in income.

It certainly isn't guaranteed that ABX will close at or above 8.5 on December 24th, but it seems likely. Let's say it does. That means the 8.5 calls would be exercised, and your ABX stock would be called away at a price of 8.5.

You would have a cost basis of $7,890, and net proceeds of $8,500, for a gain of 7.7% over 18 days. That is an annualized rate of 155%.

If ABX closes below 8.5, you continue writing weekly or monthly calls against the stock, and managing the trades, to generate additional income. And if you do get your stock called away, just wait for a minor pullback and re-enter a covered call.

Are you still a little unsure? Let's use seasonal analysis and think in terms of probability. A 7.7% gain over the next 3 weeks sounds nice. Frankly, if we could do that on every, or even most trades, we would all have beachfront homes in tropical locations. So how likely is ABX to come through, this time of year, with the gain necessary to return 7.7% on a covered call?

We can't factor in outside influences on the price of gold, or Barrick Gold Corp. Those are unpredictable. But seasonal analysis can give us an idea of how volatile the stock has been over the next 3 weeks, and how likely significant losses are.

What would you consider an acceptable loss? This is a factor I consider in many trade setups. It makes a difference in determining trade success probabilities.

If the stock didn't go anywhere in this covered call trade, you would end up with a 2.5% return, over 18 days, on the $7,890 you risked. And say the stock dropped to 7.5 by December 24th. The 7.3% drop in the stock is offset by the premium received, so the loss would be only 5%. And with a covered call trade where the stock ends up below the strike price and you are experiencing a loss, you can ‘adjust' by writing a second call against it right after expiration, thereby possibly recovering the loss and ending up with a gain.  So when evaluating this covered call trade, I might think a 7.3% drop in the stock price is acceptable (that is, a net 5% loss), while trying to make 7.7% return.

Now, how likely is ABX to experience a 7+% loss over the next 3 weeks? I turn to the seasonal pattern, the historical track record of the stock over the next 3 weeks:

In the past 30 years, over the next 3 weeks ABX has lost 7% or more only 3 times. A covered call trade, where a gain, or less than 7% drop in the price of the stock would have been acceptable because it could probably be made up in subsequent time periods, occurred 90% of the time. These are pretty good odds for any trade.

As long as outside influences stay away, the evidence of accumulation in this stock, along with the good track record for the next 3 weeks, makes this 7.7% targeted gain trade a high probability trade.

Of course, there's much more you need to know and many more stocks you can capitalize upon each and every day.  To find out more, please click on the following link: www.markettamer.com/seasonal

By Gregg Harris, MarketTamer Chief Technical Strategist

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Gregg Harris is the Chief Technical Strategist at MarketTamer.com.

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