We recently discussed covered calls as an options strategy through an ETF that could help investors generate income from their stock holdings. This strategy collects option premium by selling a call option against an equity position. If the stock is taken out, meaning the contract is eliminated before it expires or is closed, the call is "backed" by the investor's stock holdings.
Covered call writing is generally considered a suitable strategy for neutral to slightly optimistic market conditions. It offers some downside protection for stocks that an investor does not want to sell at this time.
Today we will explain how investors can devise covered call strategies on Apple (NASDAQ 🙂 stocks, one of Wall Street's favorite stocks.
Basics of Options
For those new to options, here are some basic terms you should know:
Options are versatile derivatives that can be used as hedging or speculative instruments.
As financial contracts, options give the buyer of the option the right – but not the obligation – to buy or sell the underlying asset, such as a stock, at a fixed price on or before a specified future date.
The owner of an option contract has the right to exercise it. When an option buyer (or holder) exercises the option, he invokes the terms of the option.
An option is long means that the investor has bought the asset.
The buyer of an option contract pays a premium.
The right to buy the underlying is a call option, while the right to sell is a put option.
The exercise price is the price at which an option contract can be exercised.
The expiration date is the future date and time that an options contract will expire.
Now that we've introduced the basic terminology, let's move on to covered conversations.
Initiation of Covered Call Position in a Stock
A call option gives the buyer the right to buy a share at a strike price before or on the expiration date. In the US, weekly stock options expire every Friday, while monthly options expire on the third Friday of each month.
The seller (or writer) of the option contract is required to sell the stock at the strike price if the option is exercised.
As we have already noted, the option is "covered" when the seller of a call option owns the underlying stock. The seller of the call option is able to deliver the shares without having to buy them at an unknown price in the open market.
A large number of investors write call options to avoid the premium received on the sale of a covered call as income. They prefer to write options on their holdings if they believe the stock value is unlikely to increase until the option expires.
A covered call position also provides limited downward protection. So a covered call could be appropriate when an investor thinks the price could fall in the short term.
Finally, a strike price above the current price can also act as a target price for the sale. If the stock price rises and reaches the strike price, it would meet the investor's sell price target. In other words, such a covered phone call could help reduce both the greed and fear factors in the equation.
There are no free lunches on Wall Street, and each investment strategy has a unique set of pros and cons.
Apple
Current price: $ 135.09
52 weeks range: $ 53.15 – $ 145.09
1-Year Price Change: Up About 75%
Dividend Yield: 0.6%
Consumer electronics giant Apple released FY21 on January 27, 2021. Sales were $ 111.4 billion, up 21% year-over-year (yoy). It was the highest sales for the Cupertino, California-based company ever.
Net income was $ 28.8 billion, up 29%. Earnings per diluted share for the first quarter were $ 1.68 and increased 35% year on year. Cash and cash equivalents were $ 36 billion, down 5%.
Apple Covered Calls
AAPL shares are up approximately 75% in the past 12 months, hitting a record high of $ 145.09 January 25th. The forward P / E and P / S ratios are at 31.35 and 7.91 respectively, indicating a frothy level of valuation.
Those investors watching technical charts should note that the long-term technical message is a "buy", while the short-term oscillators are at an overbought level.
A momentum share like Apple can be bought over for a long time. Still, some selling pressure, especially around the date of the earnings report, is also common.
To use the covered call strategy, one must own shares of Apple. For every 100 shares held, the strategy requires the trader to sell one call option with an expiration date at some point in the future.
As of this writing, Apple stock is trading at $ 135.09. A stock option contract on Apple (or any other stock) is the option to buy (or sell) 100 shares of Apple (in this case).
Investors who think that short-term gains can be taken in Apple stock soon could use a somewhat in-the-money (ITM) covered call. A call option is ITM if the market price (here $ 135.09) is higher than the strike price.
The investor would thus buy (or already own) 100 Apple shares for $ 135.09 and simultaneously sell an AAPL call option dated February 19, 2021 with 134 strikeouts. This option is currently being offered at a price (or premium) of $ 4.60.
A buyer of an option would have to pay $ 4.60 x 100 (or $ 460) in premium to the seller of the option.
This call option will stop trading on Friday February 19, 2021.
The 134 strike offers more downside protection than a phone call for the money (ATM) or out-of-the-money (OTM).
If the strike price of an option is identical or very close to the current market price, it is an ATM option. In this case, a call with 135 strikes would be ATM.
A call option is considered OTM when the strike price is higher than the current share price. In this case, a call of 136 strikes would be OTM.
Assuming a trader entered into this covered call trade at $ 135.09, the maximum return at maturity would be $ 351, ie ($ 4.60 – ($ 135.09- $ 134)) X100, excluding trade commissions and fees.
Risk / Reward Profile for Unsupervised Covered Call
The maximum profit from an ITM covered call is equal to the extrinsic value of the short call option.
The intrinsic value of an option is the tangible value of the option if it were to be exercised now. Thus, the intrinsic value of our Apple call option is ($ 135.09- $ 134) X100, or $ 109.
The extrinsic value of an option is the difference between the market price of an option (or its premium) and its intrinsic price. In this case, the extrinsic value would be $ 351, i.e. ($ 460 – $ 109). Extrinsic value is also called time value.
The trader realizes this $ 351 profit as long as the price of AAPL stock at maturity remains above the strike price of the call option (i.e., $ 134).
At maturity, this transaction would break even at an AAPL stock price of $ 130.49 (i.e. $ 134- $ 3.51), excluding trading fees and expenses.
Another way to think about this breakeven price is to subtract the call option premium ($ 4.60) from the price of the underlying Apple stock when we initiated the covered call (i.e. $ 135.09 ).
On February 19, if AAPL shares close below $ 130.49, the transaction would begin to lose money within this covered call setup. Thus, by selling this covered call, the investor has some protection against a potential loss. In theory, the price of a stock could drop to $ 0.
What if Apple Stock Hits a New Record?
As we noted earlier, such a covered call would potentially limit the upside profit. The risk of not participating fully in the potential valuation of Apple stock wouldn't appeal to everyone. However, within their risk / return profile, others may find that acceptable in exchange for the premium received.
For example, if Apple stock hit a new record and close at $ 170 on February 19, the trader's maximum return would still be $ 351. In that case, the option would be deep ITM and likely exercised. Brokerage fees may also be charged if the stock is called away.
Ex-Dividend Date
Finally, we must remind readers that Apple stock will go ex-dividend on February 5th. business for covered call writers. An investor must own AAPL shares at market close on February 4 to receive this dividend.
As the writer of the Apple-covered call, the trader may be subject to early practice as the buyer of the option may wish to receive this dividend.
Such an early exercise usually takes place the day before the ex-dividend date and in the case of ITM options, which do not have much time value.
Call writers should be aware of the ex-dividend date, as the covered call strategy may need to be managed.
Bottom Line
Buying 100 Apple shares for $ 135.09 would require an investment of $ 13,509. Many investors may not be willing to commit to such an amount. They sometimes prefer to have a & # 39; covered phone call for poor people & # 39; together, a strategy we'll discuss in next week's post.
Seasoned investors would agree that, in the long run, the direction of broader stock indices is going up. The same goes for stocks of robust companies with income and profits.
Still, stocks, like other financial assets, take a breather every now and then. The exact timing in the market when such a decline could occur is not easy to know. But options strategies provide tools that can prepare for sideways moves or even declines in stock prices.
There are many angles involved in using different options for hedging or speculative purposes. Interested readers may want to consider putting time and effort into educating themselves, as options strategies are powerful tools along a lifetime investment journey. They can also benefit from conversations with qualified investment professionals in their jurisdictions.
