Chinese Electric Vehicle Group Xpeng (NYSE:) released May 13. Since then, XPEV shares have returned over 90%. The stock is currently trading around $44.90.
So today we outline how investors might consider a covered call strategy to protect some of their recent gains in the automaker. It could also help reduce the volatility of the portfolio position.
Over the past few months, we've been discussing how to initiate covered calls on several popular stocks. Readers unfamiliar with options should consider re-reading the first article in the series before reading this post, as well as discussing another Chinese EV darling Nio (NYSE:) stock.
Xpeng Stock's Latest Win
Recent EV stats show that there are more than 31 automakers in China in this space, and Xpeng is in the top 10. China's homegrown EV names are all striving to be the next Tesla (NASDAQ) :), whose stock is currently down about 3.4% YTD.
Xpeng was listed on the New York Stock Exchange as American Depositary Receipt (ADR) in August 2020, when it began trading at $23.10. Within weeks, it hit an all-time low of $17.11, then made a great run up to a record high of $74.49 on November 24, 2020.
Since that date it has been a downhill and choppy ride for those early shareholders. However, investors who bought after the results of the first quarter of mid-May have almost doubled their investments.
For the quarter, total revenue was RMB 2.95 billion (or $450.4 million), an increase of 616.1% over the same period in 2020. Non-GAAP base and diluted net loss per ADS was RMB 0.88 (or 13 cents).
CEO He Xiaopeng noted:
"The first quarter got off to a great start to 2021 with record-breaking vehicle deliveries, despite seasonally slower auto demand and semiconductor shortages."
For the second quarter of 2021, the company expects total sales of between RMB3.4 billion and RMB3.5 billion, representing a year-over-year increase of 475.5% to 492.4%.
XPEV shares trade at 27.7 times sales. In comparison, the P/S ratio for Tesla and Nio shares is 21.4x and 18.3x.
Covered calls on XPEV shares
For every 100 shares held, the trader to sell one XPEV call option with an expiration date sometime in the future.
Intraday Tuesday, Xpeng stock traded at $44.90. That is why we use that price for this article.
Investors who believe that short-term profit-taking may occur soon should use a lightly in-the-money (ITM) covered call. A call option is ITM if the market price (here $44.90) is higher than the strike price ($40).
So, the investor would buy (or already own) 100 shares of XPEV stock for $44.90 and simultaneously sell an XPEV August 20, 2021, 40-strike call option. This option is currently offered at a price (or premium) of $7.33.
An option buyer would have to pay $7.33 X 100 (or $733) in premium to the option seller. This call option ends on Friday, August 20.
Assuming a trader would now enter this covered call trade for $44.90, the maximum return would be $243, i.e. ($733 – ($44.90 – $40) X 100), excluding trading commissions and costs.
Risk/reward profile for unsupervised covered call
The maximum profit of an ITM covered call is equal to the extrinsic value of the short call option.
The NAV would be the tangible value of the option if it were exercised now. So the NAV of our Xpeng call option is ($44.90 – $40) X 100 or $490.
The extrinsic value is the difference between the market price of an option (or the premium) and the intrinsic price. Here the extrinsic value would be $243, i.e. ($733 – $490). Extrinsic value is also known as time value.
The trader realizes this gain of $243 as long as the price of XPEV shares remains above the strike price of the call option (i.e., $44.00) upon expiration.
On expiration, if the stock closes below the strike price, the option would not be exercised, but instead expire worthless. Then the stock owner with the covered call position gets to keep the stock and the money (premium) he/she was paid for selling the option.
At expiration, this trade would break even at an Xpeng stock price of $37.57 (i.e. $44.90 – $7.33), excluding trading commissions and fees.
On August 20, if Xpeng shares close below $37.53, the trade would start losing money within this covered call setup.
Therefore, by selling the covered call, the investor has some protection against a potential loss in the event of a fall in the underlying stock. In theory, the price of a stock could drop to $0.
What if XPEV shares hit a new record?
As we have noted in previous articles, a covered call limits the upside potential. The risk of not fully participating in the potential appreciation of Xpeng stock may not appeal to everyone. However, within their risk-return profile, others may find this acceptable in return for the premium received.
For example, if XPEV stock reached a new high for 2021 and closed at $75 on August 20, the trader's max return would still be $243. In such a case, the option would be deep ITM and likely to be exercised. Brokerage fees may also be charged if the shares are recalled.
Bottom Line
Xpeng stocks have been on fire for the past six weeks and we are optimistic about the Chinese EV maker in the long term. With a market cap of about $36 billion, it still has room for growth. However, such a covered call strategy could help navigate potential sideways moves or even declines in XPEV price in the coming weeks.
