Semiconductor stocks have been volatile in recent weeks, partly due to ongoing uncertainties about the global chip shortage.
Most chip stocks have been under pressure since the beginning of April. At the beginning of March, Micron Technology (NASDAQ 🙂 was at $ 88.35. Now it is $ 79.77. Likewise, on March 30, Advanced Micro Devices (NASDAQ 🙂 was at $ 75.38. It has since been trading in a range around $ 75.31.
We discussed covered calls to protect recent gains and reduce portfolio volatility for AMD and MU holders.
Today we will discuss NVIDIA (NASDAQ 🙂 and Taiwan Semiconductor Manufacturing (NYSE 🙂 to see how potential investors could set up a covered call trade to potentially take advantage of a sideways to slightly upward movement in both herds.
As regular readers will know, a covered call position requires ownership of 100 shares of a particular company. However, buying 100 shares of NVDA and TSM would cost about $ 56,800 and $ 11,600 respectively – a significant investment for many people.
In such a case, some investors prefer to put a "covered call from the poor" on the stock instead. That's why we're introducing a diagonal debit spread on NVIDIA and Taiwan Semiconductor Manufacturing.
We will use LEAPS options, "Long-Term Equity Anticipation Securities." Readers can also see websites that refer to them as LEAP options or LEAPs. Such a position is sometimes used to replicate a covered call position at a significantly lower cost.
Investors new to options may want to review a similar article we published on Apple (NASDAQ 🙂 before reading this post. For many readers, today's piece should help increase their understanding of options. For more experienced investors, we aim to offer ideas for future trades.
A Diagonal Debit Spread on NVIDIA Stocks
Current Price: $ 568.49
52 -Week Range: $ 319.87 – $ 648.57
Year-to-Date (YTD) Price Change: Up 8.8%
Dividend Yield: 0.11%
In this LEAPS backed call strategy, a trader first buys a “ longer term” call with a lower strike price. At the same time, the trader sells a " shorter term" call with a higher strike price, creating a long diagonal spread.
In other words, the call options for the underlying stock (i.e. NVIDIA in this case) have different strikes and different expiration dates. The trader goes long one option and short the other to make a diagonal spread.
Both the profit potential and the risk are limited. The trader establishes the position for a net write-off (or cost). The net depreciation represents the maximum loss.
Most traders adopting such a strategy would be slightly optimistic about the underlying asset – here NVDA.
Instead of buying 100 NVIDIA shares, the trader would buy a deep money LEAPS call option with that LEAPS call acting as " surrogate" for holding the NVDA shares .
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Mid-Tuesday as we write this, NVIDIA was trading at $ 568.49.
For the first leg of this strategy, the trader could purchase a deep-in-the-money (ITM) LEAPS call, such as the NVDA January 20, 2023, 430-strike call option. This option is currently being offered at $ 185.88 (mid-current bid and spread). In other words, it would cost the trader $ 18,588 instead of $ 56,849 to own this call option, which expires after more than a year and a half.
The delta of this option is approximately 0.80. Delta shows the amount that an option's price is expected to move based on a $ 1 change in the underlying asset.
In this example, if the NVDA stock were to rise $ 1 to $ 569.49, the current option price of $ 185.88 is expected to increase by approximately 80 cents based on a delta of 0.80. However, the actual change may be slightly more or less depending on various other factors beyond the scope of this article.
So the delta of an option increases as one goes deeper into the money. Traders would use deep ITM LEAPS attacks because as delta approaches 1, the price movements of a LEAPS option begin to mirror those of the underlying stock. In simple terms, a delta of 0.80 would be the same as owning 80 NVIDIA shares in this example (as opposed to 100 in a regular covered call).
For the second part of this strategy, the trader sells a short-term out-of-the-money (OTM) call, such as the NVDA July 16, 2021, 580-strike call option. The current premium of this option is $ 29.65. In other words, the option seller would receive $ 2,965, not including trading commissions.
There are two expiration dates in the strategy, making it quite difficult to give an exact formula for a break-even point in this transaction.
Various brokers or online websites may offer " Profit and Loss Calculators" for such a trade setup. To calculate the value of the last month option (ie LEAPS call) when the first month (ie the shorter) call option expires, a pricing model is required to make a " estimate" for a pause point.
Maximum Earnings Potential
The maximum potential is realized when the stock price equals the strike price of the short call at the expiration date of the short call.
In other words, the trader wants the NVIDIA stock price to stay as close as possible to the strike price of the short option (ie $ 580 here) at maturity (on July 16, 2021), without going above it.
In our example, the maximum return would theoretically be approximately $ 3,653 at a price of $ 580.00 at maturity, excluding trading commissions and fees. (We arrived at this value using an online profit and loss calculator.)
Without the use of such a calculator, we could also arrive at an estimated dollar value. Let's see:
The seller of the option (i.e., the trader) received $ 2,965 for the option sold.
Meanwhile, the underlying NVDA share rose from $ 568.49 to $ 580, a difference of $ 11.51 for 1 share of NVIDIA or $ 1,151 for 100 shares.
As the delta of the long LEAPS option is taken as 0.8, the value of the long option will theoretically increase by $ 1151 X 0.8 = $ 920.8 (in practice, however, it can be more or less less than this value)
The total of $ 2,965 and $ 920.8 equals $ 3,885.8. While it is not the same as $ 3,653, we can consider it a good appraised value. The main reason behind the difference is that the delta of the LEAPS option was not exactly 0.8.
Understandably, if the strike price of our long option had been different (i.e., not 430), the delta would have been different as well. Then we should use that delta value to arrive at the estimated ultimate profit or loss value.
Thus, by not initially investing $ 56,849 in 100 shares of NVIDIA, the trader's potential returns are exploited.
In other words, the premium the trader initially receives for the sale of the shorter call option (i.e. $ 2,965) represents a higher percentage of the initial investment of $ 18,588 than if the trader purchased 100 shares of NVIDIA for $ 56,849.
Ideally, the trader hopes that the short call will be out of the money. Then the trader can sell one call after another, until the long LEAPS call ends in about a year and a half.
Position Management
Active position management in a diagonal debit spread is usually more difficult for novice traders.
If NVIDIA exceeds $ 580 on July 16, the position will yield less than the potential maximum return as the short-term option begins to lose money.
Then the trader might feel the need to close the trade early if the NVDA price skyrockets and the short conversation goes deep into ITM. In that case, the trader may have to close the whole trade and start over, or put together alternative options strategies.
In a normal covered call, the trader does not necessarily mind being assigned the short option as he / she also owns 100 NVIDIA shares. However, on a covered call from a poor person, the trader would not necessarily want to get the short call as he / she doesn't own those NVDA shares yet.
On July 16, this LEAPS-backed call trade would also theoretically lose money if the NVIDIA stock price falls to about $ 538 or below. However, the actual breakeven point may differ as there are several variables that affect the price of an option. Understandably, the price of a stock could fall to $ 0, decreasing the value of the long call with it.
Finally, we must remind readers that deep ITM LEAPS options typically have high bid / offer spreads. Therefore, any time the trader buys or sells such a LEAPS option, there can be significant transaction costs.
Now let's also take a look at TSM shares.
A diagonal write-off on TSM stock
Current price: $ 111.63
52 weeks Range: $ 49.61 – $ 142.19
YTD Price Change: Up 1.59%
Dividend Yield: 2.62%
For the first leg of this strategy, the trader could purchase a deep-in-the-money (ITM) LEAPS call, such as the TSM January 20, 2023, 90-strike call option. This option is currently being offered for $ 29.55. So it would cost the trader $ 2,955 instead of $ 11,163 to own this call option, which will expire after more than a year and a half.
Like the example of NVDA shares, the delta of this option is also approximately 0.80.
For the second part of this strategy, the trader sells a short-term out-of-the-money (OTM) call, such as the TSM July 16, 2021, 115-strike call option at a premium of $ 4.10. Thus, the option seller would receive $ 410 excluding trading commissions.
Maximum Earnings Potential
As we saw above, the maximum potential is realized when the stock price equals the strike price of the short call on the short call's expiration date.
In other words, the trader wants the TSM stock price to stay as close as possible to the strike price of the short option (ie $ 115 here) at maturity (on July 16, 2021), without going above it.
In our example, the maximum return would theoretically be approximately $ 634 at a price of $ 115 at maturity. (Again, we arrived at this value using an online profit and loss calculator.)
Without the use of such a calculator, we could also arrive at an estimated dollar value. Let's see:
The seller of the option (i.e., the trader) received $ 410 for the option sold.
Meanwhile, the underlying TSM stock rose from $ 111.63 to $ 115, a difference of $ 3.37 for 1 share of TSM or $ 337 for 100 shares.
Since the delta of the long LEAPS option is taken as 0.8, the value of the long option will theoretically increase by $ 337 x 0.8 = $ 269.6 (in practice, however, it can be more or less less than this value).
The total of $ 410 and $ 269.6 comes to $ 679.6. While it is not the same as $ 634, we can consider it a good appraised value.
By not initially investing $ 11,163 in 100 shares of TSM, the trader's potential returns are thus exploited.
The trader wants the short call to be out of the money. Then the trader can sell one call after another, until the long LEAPS call expires in about a year and a half.
Finally, if TSM moves above $ 115 on July 16, the position will yield less than its potential maximum return as the short-term option begins to lose money. Next, the trader must take appropriate action based on his or her objectives.
