AMD Covered Call: Amid Chip Shortage, Minimize Volatility Ahead Of Earnings
Investing.com | Mar 31, 2021 08:38AM ET
Semiconductor group Advanced Micro Devices (NASDAQ:AMD) is one of the most important computer and graphics chip-makers. Year-to-date, its shares are down close to 19%. By comparison, the widely followed Philadelphia Semiconductor Index is up about 8%.
Despite the decline in AMD stock in recent weeks, the shares are still up over 65% in the past 12 months. On Jan. 11, they hit a record high of $99.23. Now, AMD stock is hovering at $75.
We recently focused on the semiconductor industry with an emphasis on the current chip shortage that is also affecting a large number of companies in other sectors, including car manufacturers.
Many analysts concur that most semiconductor stocks are likely to benefit from the ongoing supply constraint. But it is not easy to know how each chip business will be affected. Amidst the uncertainty, we can bet on increased volatility in the sector, especially during the upcoming earnings season. Therefore, today, we look at Advanced Micro Devices, which is expected to release Q1 earnings in late April, and provides the example for 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 share price. Readers who are new to options might want to revisit the initial article in the series before reading this post.
h2 Advanced Micro Devices/h2Intraday Price: $75.38
52-Week Range: $41.70 - $99.23
1-Year Price Change: Up about 65%
Advanced Micro Devices focuses on chips used for computer processing. AMD also designs flash memories, graphic processors and components for electronic goods.
As one of the most important names in the chip space, it now boasts a market capitalization of about $91 billion, a number that has grown significantly over the past several years.
AMD has especially been successful in reducing the size of central processing unit (CPU) nodes. Yet, its products also are more powerful than those of its rivals. Companies that use AMD chips include Apple (NASDAQ:AAPL), Boeing (NYSE:BA), Electronic Arts (NASDAQ:EA), Microsoft (NASDAQ:MSFT) and Sony (NYSE:SNE).
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Over a decade ago, the group moved to a “fabless” semiconductor business, outsourcing the manufacturing process to another company. AMD spun off its factories into a joint venture called Global Foundries, whereby it can still keep an eye on this crucial part of the process.
AMD announced Q4 and full-year 2020 results in late January. Quarterly revenue was $3.2 billion, up 53% year-over-year (YoY). Full-year revenues of $9.76 billion meant an increase of 45% from 2019. Quarterly net income was $1.78 billion and diluted earnings per share came in at $1.45.
For Q1, management’s revenue guidance was $3.1 billion-$3.3 billion, an increase of 79% YoY. Despite the “robust demand for high-performance computing across the PC, gaming and data center markets,” following the results profit-taking kicked in and investors have been hitting the “sell” button over the past two months.
AMD stock's current P/S and forward P/E ratios of 9.51 and 40.49, respectively, mean a frothy valuation level. As well, increasing yields are putting pressure on tech stocks. Given the ramp-up in the AMD share price over the past 12 months, a covered call might be an appropriate strategy for some investors. As a momentum stock, shares of the chip-maker will be volatile around the quarterly earnings due in several weeks.
h2 Covered Calls On AMD Stock/h2
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.
Intraday Tuesday, AMD stock was trading at $75.38. Therefore, for this post, we'll use this price.
A stock option contract on AMD (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, $75.38) is above the strike price ($72.50).
So the investor would buy (or already own) 100 shares of AMD stock at $75.38 and, at the same time, sell an AMD May 21, 2021, 72.5-strike call option. This option is currently offered at a price (or premium) of $6.20.
An option buyer would have to pay $6.20 X 100 (or $620) 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 72.5-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 $75.38, at expiration, the maximum return would be $332, i.e., ($620 - ($75.38 - $72.50) X 100), excluding trading commissions and costs.
h2 Risk/Reward Profile For Unmonitored Covered Call/h2
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 AMD call option's intrinsic value is ($75.38 - $72.50) X 100, or $288.
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 $332, i.e., ($620 - $288). Extrinsic value is also known as time value.
The trader realizes this gain of $332 as long as the price of AMD stock at expiration remains above the call option's strike price (i.e., $72.50).
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 AMD stock price of $69.18 (i.e., $72.50 - $3.32), excluding trading commissions and costs.
Another way to think of this break-even price is to subtract the call option premium ($6.20) from the underlying AMD stock price when we initiated the covered call (i.e., $75.38).
On May 21, if AMD stock closes below $69.18, 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.
h2 What If AMD Stock Reaches New All-Time High?/h2As we have noted in earlier articles, such a covered call would limit the upside profit potential. The risk of not participating in AMD 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 AMD stock were to reach a new high for 2021 and close at $100 on May 21, the trader's maximum return would still be $332. 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 $72.5 call before expiry on May 21. Depending on her/his views and objectives regarding the underlying AMD 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.
Bottom Line
AMD stock has been on fire over the past year, and long term, we are bullish on the company. However, the semiconductor industry is cyclical. As a result, chip shares experience more extreme boom-and-bust tendencies than many other businesses. And the current chip shortage has meant even more volatility than usual for semiconductor names including Advanced Micro Devices.
The exact market-timing of when AMD 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.
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