We recently discussed covered calls as an options strategy via an ETF that could help investors generate income from their stock holdings. This strategy collects option premium by selling a call option against a stock position. If the shares are called away, meaning the contract is eliminated before expiration or conclusion, the call is "covered" by the investor's stock holding.
Covered call writing is typically regarded as a suitable strategy for neutral-to-slightly bullish market conditions. It provides some downside protection for stocks that an investor is not willing to sell at the moment.
Today we'll explain how investors could devise covered call strategies on Apple (NASDAQ:AAPL) shares, one of Wall Street's darling stocks.
Options Basics
For those new to options, here are a few basic terms to know:
Options are versatile derivative products that can be used as hedging or speculative tools.
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 set price on or before a certain date in the future.
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.
Being long an option means the investor has purchased the asset.
The buyer of an option contract pays a premium.
The right to purchase the underlying security is a call option, while the right to sell is a put option.
The strike price is the price at which an options contract can be exercised.
The expiration date is the future date and time an options contract expires.
Now that we've introduced the basic terminology, let’s move on to covered calls.
Initiating Covered Call Position In A Stock
A call option gives the buyer the right to buy a stock at a strike price before or on the expiration date. In the U.S., weekly stock options expire every Friday, while monthly options expire the third Friday of each month.
The seller (or the writer) of the option contract is obligated to sell the stock at the strike price if the option is exercised.
As we have already noted, when the seller of a call option owns the underlying shares, the option is “covered.” The seller of the call option is able to deliver the shares without the need to purchase them at an unknown price in the open market.
A large number of investors write call options to keep the premium received from selling a covered call as income. They prefer to write options on their holdings when they think the stock value is not likely to increase until the expiry of the option.
A covered call position also offers a limited amount of downside protection. Thus, a covered call could be appropriate when an investor believes the price could decline in the short term.
Finally, a strike price above the current price can also act as a target selling price. If the stock price appreciates and hits the strike price, it would meet the investor's selling-price objective. Put another way, such a covered call might help decrease both the greed and fear factors in the equation.
There are no free lunches on Wall Street, and each investment strategy comes with a unique set of advantages and disadvantages.
Apple
Current Price: $135.09
52-Week Range: $53.15 - $145.09
1-Year Price Change: Up about 75%
Dividend Yield: 0.6%
Consumer electronics giant Apple released FY21 Q1 earnings on Jan. 27, 2021. Revenue was $111.4 billion, up 21% year-over-year (YoY). It was the highest revenue figure for the Cupertino, California-based company ever.
Net income was $28.8 billion, an increase of 29%. Q1 earnings per diluted share came in at $1.68, and increased 35% YoY. Cash and equivalents were $36 billion, down 5%.
Apple Covered Calls
AAPL stock is up about 75% in the past 12 months and hit a record high of $145.09 on Jan. 25. Its forward P/E and P/S ratios stand at 31.35 and 7.91, respectively, pointing to a frothy valuation level.
Those investors who pay attention to technical charts should note that the long-term technical message is a "buy," while short-term oscillators are at overbought levels.
A momentum stock like Apple can stay overbought for long periods of time. Yet, some selling pressure, especially around the earnings report date, is also common.
To use the covered call strategy, one has to own shares of Apple. For every 100 shares held, the strategy requires the trader sell one call option with an expiration date at some time in the future.
As we write, 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 believe there could be some short-term profit-taking soon in Apple shares might use a slightly in-the-money (ITM) covered call. A call option is ITM if the market price (here, $135.09) is above the strike price.
So the investor would buy (or already own) 100 shares of Apple stock at $135.09 and, at the same time, sell an AAPL Feb. 19, 2021, 134-strike call option. This option is currently offered at a price (or premium) of $4.60.
An option buyer would have to pay $4.60X100 (or $460) in premium to the option seller.
This call option will stop trading on Friday, Feb. 19, 2021.
The 134-strike offers more downside protection than an at-the-money (ATM) or out-of-the-money (OTM) call.
When an option's strike price is identical or very close to the current market price, it is an ATM option. In this case, a 135-strike call would be ATM.
A call option is considered OTM when the strike price is higher than the current price of the stock. In this case, a 136-strike call would be OTM.
Assuming a trader would enter this covered call trade at $135.09, at expiry the maximum return would be $351, i.e., ($4.60 – ($135.09-$134))X100, excluding trading commissions and costs.
Risk/Reward Profile For Unmonitored Covered Call
An ITM covered call's maximum profit 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 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 the premium) and its intrinsic price. In this case, the extrinsic value would be $351, i.e., ($460 – $109). Extrinsic value is also known as time value.
The trader realizes this gain of $351 as long as the price of AAPL stock at expiry remains above the strike price of the call option (i.e., $134).
At expiration, this trade would break even at an AAPL stock price of $130.49 (i.e., $134-$3.51), excluding trading commissions and costs.
Another way to think of this break-even 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 Feb. 19, if AAPL stock closes below $130.49, the trade would start losing money within this covered call set-up. Therefore, by selling this covered call, the investor has some protection against a potential loss. In theory, a stock's price could drop to $0.
What If Apple Stock Reaches A New All-Time High?
As we have noted before, such a covered call would limit the upside profit potential. The risk of not participating in Apple stock's potential appreciation fully would not appeal to everyone. However, within their risk/return profile, others might find that acceptable in exchange for the premium received.
For example, if Apple stock were to reach a new record high and close at $170 on Feb. 19, the trader's maximum return would still be $351. In such a case, the option would be deep ITM and would likely be exercised. There might also be brokerage fees if the stock is called away.
Ex-Dividend Date
Finally, we should remind readers that Apple stock goes ex-dividend on Feb. 5, a date that matters to covered call writers. An investor has to own AAPL shares by close of market on Feb. 4 in order to receive this dividend.
As the writer of the Apple covered call, the trader might become subject to an early exercise since the buyer of the option might want to capture this dividend.
Such an early exercise usually takes place on the day before the ex-dividend date and in the case of ITM options, which do not have much time value.
Call writers need to be cognizant of the ex-dividend date as the covered call strategy might require managing.
Bottom Line
Buying 100 shares of Apple stock at $135.09 would require an investment of $13,509. Many investors may not be ready to commit such an amount. They sometimes prefer to put together a "poor person's covered call,’ a strategy we will cover in next week's post.
Seasoned investors would concur that, over the long-run, the direction of broader equity indices is up. The same holds true for shares of robust companies with revenues and profits.
Yet, stocks, as well as other financial assets, take a breather every now and then. The exact market-timing of when such a decline may happen is not easy to know. But options strategies provide tools that might prepare for sideways moves or even falls in price in stocks.
There are many angles involved in using various options for hedging or speculative purposes. Interested readers might consider putting in the time and effort to educate themselves as options strategies are powerful tools in a life-long investment journey. They could also benefit from talking to qualified investment professionals in their jurisdictions.