Mastercard: A Covered Call For Nervous Bulls In The ‘Just Charge It’ Stock

Source: InvestingPro

In other words, fundamental valuations suggest shares could decline by around 2%.

At present, MA’s P/E, P/B and P/S ratios are 36.7x, 49.5x and 17.5x. Comparable metrics for peers stand at 35.3x, 8.0x and 5.4x. These metrics reveal that MA stock may be slightly overvalued at the current stock price.

Our expectation is for Mastercard shares to trade in a wide range, between $340 and $380, to build a base in the coming weeks. Afterwards, MA shares could potentially start a new leg up.

Mastercard bulls who believe the decline in the stock is likely to come to an end could consider investing now. Their target price would be $424.67, as per the target provided by analysts.

Although investors might want to buy MA stock for their long-term portfolios, they could also be nervous about further volatility in the coming weeks. Therefore, some might prefer to put together a "poor man’s covered call" on the stock.

So, today we introduce a diagonal debit spread on Mastercard by using LEAPS options, where both the profit potential and the risk are limited.

Investors who are new to the strategy might want to revisit our previous posts on LEAPS options first before reading further.

Most option strategies are not suitable for all retail investors. Therefore, the following discussion on MA stock is offered for educational purposes and not as an actual strategy to be followed by the average retail investor.

Price at time of writing: $359.60

In such a poor man’s covered call, 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.

Thus, the call options for the underlying stock have different strikes and different expiration dates. The trader goes long one option and shorts the other.

Most traders opting for this type of strategy would be mildly bullish on the underlying security. Instead of buying 100 shares of MA, the trader would purchase a deep in the money LEAPS call option, where that LEAPS call acts as a “surrogate” for owning the stock.

For the first leg of this strategy, the trader might buy a deep in the money (ITM) LEAPS call, like the MA Jan. 19, 2024, 290-strike call option. This option is currently offered at $103.40. It would cost the trader $10,340 to own this call option, which expires in about a year and half, instead of $35,960 to buy the 100 shares outright.

The delta of this option is close to 80. Delta shows the amount an option’s price is expected to move based on a $1 change in the underlying security.

Based on a delta of 80, if MA stock goes up $1 to $360.60, the current option price would be expected to increase by approximately 80 cents. However, the actual change might be slightly more or less depending on several other factors that are beyond the scope of this article.

For the second leg of this strategy, the trader sells a slightly out of the money (OTM) short-term call, like the MA June 17 365-strike call option. This option’s current premium is $7.25. The option seller would receive $725, excluding trading commissions.

There are two expiration dates in the strategy, making it quite difficult to give an exact formula for a break-even point. Different brokers might offer “profit-and-loss calculators” for such a trade setup.

The maximum potential is realized if the stock price is equal to the strike price of the short call on its expiration date. So the trader wants the MA stock price to remain as close to the strike price of the short option (i.e., $365) as possible at expiration on June 17, without going above it.

Here, the maximum return, in theory, would be about $1,114 at a price of $365 at expiry, excluding trading commissions and costs. (We arrived at this value using an options profit-and-loss calculator). Without the use of such a calculator, we could also arrive at an approximate dollar value. Let’s take a look:

The option seller (i.e., the trader) received $725 for the sold option. Meanwhile, the underlying Mastercard stock increased from $359.60 to $365, a difference of $5.40 per share, or $540 for 100 shares.

Because the delta of the long LEAPS option is taken as 80, the value of the long option will, in theory, increase by $540 X 0.8 = $432

However, in practice, it might be more or less than this value. There is, for example, the element of time decay that would decrease the price of the long option. Meanwhile, changes in volatility could increase or decrease the option price as well.

The total of $432 and $725 comes to $1,157. Although it is not the same as $1,114, we can regard it as an acceptable approximate value.

Understandably, if the strike price of our long option had been different (i.e., not $290), its delta would have been different, too. Then, we would need to use that delta value to arrive at the approximate final profit or loss value.

Here, by not investing $35,960 initially in 100 shares of Mastercard, the trader’s potential return is leveraged.

Ideally, the trader hopes the short MA call will expire out of the money, or worthless. Then, the trader can sell one call after the other, until the long Mastercard LEAPS call expires in close to two years.

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