After Rapid Rise, Freeport-McMoRan Options Could Protect Gains In Miner's Stock

Today, we look at Freeport-McMoRan—which is expected to release Q1 earnings on Apr. 22 before market open—to provide today's example of a covered call. Over the past several weeks, we have discussed how investors could consider writing covered calls on their stock holdings.

Such an option strategy could help decrease the volatility of their position and offer shareholders some protection against declines in the FCX share price. Readers who are new to options might want to revisit the initial article in the series before reading this post.

Intraday Price: $36.42
52-Week Range: $7.30 - $39.10
Year-to-date Price Change: Up about 41%
Dividend Yield: 0.82%

Phoenix-based Freeport-McMoRan operates large and geographically diverse mining assets with reserves of copper, gold and molybdenum. FCX’s portfolio of assets includes the Indonesian Grasberg mining complex, one of the largest copper and gold mines in the world. It also has significant mining operations in North and South America.

The company released Q4 and full-year metrics at the end of January. Quarterly revenue increased by 14.9% year-over-year, reaching $4.5 billion. Adjusted net income of $566 million translated into an EPS of 39 cents.

Investors were pleased to see that Q4 copper and gold sales came in at 3% and 9%, respectively, above October 2020 estimates. Average realized prices were $3.40 per pound for copper and $1,870 per ounce for gold. Please note that at present, respective prices for both metals are around $4.25 and $1,775.

CEO Richard C. Adkerson commented:

“We are enthusiastic about the future prospects for our business based on the positive outlook for the markets we serve, our long-lived and high-quality copper assets, our seasoned and highly motivated global organization and the critical role of copper to the technologies necessary to deliver clean energy and support the global transition to a low-carbon economy."

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The mining group shared its consolidated sales volume expectations for the first quarter and full-year 2021. Accordingly, for Q1 2021, Freeport-McMoRan expects to reach 825 million pounds of copper (compared to 729 million pounds of Q1 2020), 275,000 ounces of gold (compared to 144,000 ounces of Q1 2020) and 20 million pounds of molybdenum (compared to 21 million pounds of Q1 2020).

FCX’s forward P/E and P/S ratios currently stand at 16.39 and 3.84, respectively. Given the significant and rapid increase in the FCX share price YTD, a covered call to protect some of the recent gains might be an appropriate strategy for some investors.

For every 100 shares held, the strategy requires the trader to sell one call option with an expiration date at some time in the future.

As we write on Tuesday, the intraday price FCX stock is $36.42. Therefore, for this post, we'll use this price.

A stock option contract on FCX (or any other stock) is the option to buy (or sell) 100 shares.

Investors who believe there could be short-term profit-taking soon might use a slightly in-the-money (ITM) covered call. A call option is ITM if the market price (here, $36.42) is above the strike price ($35.00).

So, the investor would buy (or already own) 100 shares of FCX stock at $36.42 and, at the same time, sell an FCX May 21, 2021, 35-strike call option. This option is currently offered at a price (or premium) of $3.05.

An option buyer would have to pay $3.05 X 100 (or $305) in premium to the option seller. This call option will stop trading on Friday, May 21, 2021.

This premium amount belongs to the option writer (seller) no matter what happens in the future, for example, on the day of expiry.

The 35-strike offers more downside protection than an at-the-money (ATM) or out-of-the-money (OTM) call.

Assuming a trader would now enter this covered call trade at $36.42, at expiration, the maximum return would be $163, i.e. $305 - (($36.42 - $35.00) X 100), excluding trading commissions and costs.

An ITM covered call's maximum profit is equal to the extrinsic value of the short call option.

The intrinsic value would be the tangible value of the option if it were exercised now. Thus, our FCX call option's intrinsic value is ($36.42 - $35.00) X 100, or $142.

The extrinsic value 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 $163, i.e. ($305 - $142). Extrinsic value is also known as time value.

The trader realizes this gain of $163 as long as the price of Freeport-McMoRan stock at expiration remains above the call option's strike price (i.e. $35.0).

On expiration day, if the stock closes below the strike price, the option would not get exercised, but would instead expire worthless. Then, the stock owner with the covered call position gets to keep the stock and the money (premium) s/he was paid for selling the option.

At expiration, this trade would break even at an FCX stock price of $33.37 (i.e. $35 - $1.63), excluding trading commissions and costs.

Another way to think of this break-even price is to subtract the call option premium ($3.05) from the underlying FCX stock price when we initiated the covered call (i.e. $36.42).

On May 21, if Freeport-McMoRan stock closes below $33.37, 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 case of a decline in the underlying shares. In theory, a stock's price could drop to $0.

As we have noted in earlier articles, such a covered call would limit the upside profit potential. The risk of not participating in FCX stock's potential appreciation fully would not appeal to everyone. However, within their risk/return profiles, others might find that acceptable in exchange for the premium received.

For example, if FCX stock were to reach a new high for 2021 and close at $50 on May 21, the trader's maximum return would still be $163. 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.

As part of the exit strategy, the trader might also consider rolling this deep ITM call option. In that case, the trader would buy back the 35-call before expiry on May 21.

Depending on her/his views and objectives regarding the underlying FCX stock, s/he could consider initiating another covered call position. In other words, the trader could possibly roll out to a June 18 expiry call with an appropriate strike.

Finally, we should remind readers that Freeport-McMoRan stock goes ex-dividend in mid-July (exact date yet to be announced), a day that could matter to covered call writers. Because our proposed covered call expires before the next ex-dividend date, it will not matter to us on this occasion.

However, if our covered call were to expire after that date in July, we’d need to pay attention. In order to qualify for the dividend payment, a stock investor has to own shares before that ex-dividend date.

As the writer of the FCX 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

The exact market-timing of when FCX shares could take a breather is difficult to determine, even for professional traders. But options strategies provide tools that might prepare for sideways moves or even drops in price, especially around the earnings release date.

We regard covered call options as a potential way to earn additional income from your stock portfolio. Such a strategy also helps lower portfolio volatility. Interested investors might consider increasing their knowledge base.

Written By: Investing.com