Micron Technology Covered Call: Reduce Volatility, Protect Recent Gains

Shares of most chip and tech darlings of Wall Street are highly choppy in the short-term. So is MU stock. In fact, its beta is close to 1.4. Thus, theoretically, it is 40% more volatile than the market.

On Monday, we covered the chip space, with an emphasis on the cyclical nature of the industry. The current chip shortage has also contributed to the choppiness in many semiconductor names. Today, we continue the discussion by taking a closer look at MU stock and provide the example of a covered call.

We recently 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 that article before reading this post.

Intraday Price: $88.35
52-Week Range: $31.13 - $95.75
1-Year Price Change: Up about 91%

Based in Boise, Idaho, Micron Technology provides memory chips to clients in various industries, including artificial intelligence (AI), autonomous vehicles, cloud, consumer electronics, 5G wireless, gaming and machine learning.

For instance, Micron is the chip 3D XPoint manufacturing capabilities. But that segment does not yet generate much revenue.

As a side note , DRAM is a common type of random access memory (RAM) used in personal computers, workstations and servers, so primary system memory.

NAND, on November 2020 , MU shipped “the world’s first 176-layer 3D NAND flash memory." Customers, such as data centers and mobile device makers will use these new chips in applications like AI, cloud computing, 5G and the Internet of Things (IoT).

The group released Q1 FY21 metrics in early January. Revenue was $5.77 billion. A year ago, it had been $5.14 billion for the same period. Non-GAAP net income of $897 million, an increase of 63.7% year-over-year (YoY) growth. Diluted EPS also increased from 48 cents in Q1 FY20 to 78 cents in Q2 FY21.

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On Mar. 3, Micron updated the revenue and EPS guidance for the second quarter of fiscal 2021. Management now expects to generate $6.20 billion-$6.25 billion in revenue in Q2 2021 instead of its previous guidance of $5.6 billion to $6.0 billion. Non-GAAP diluted EPS guidance was also revised upward from 68-82 cents to the 93-98-cent range.

Tight chip supply, as well as higher memory chip demand were the catalysts behind the revised outlook. In other words, Micron’s chip products have a commodity-like quality and price action. When demand exceeds supply, the company can literally print profits.

MU stock's current P/S and forward P/E ratios stand at 4.56 and 19.69, respectively. The company is expected to announce full Q2 earnings on Mar. 31. Given the increase in the MU share price since the start of the year, a covered call might be an appropriate strategy for some investors. As a momentum stock, shares of the memory chip-maker will be volatile around the quarterly earnings date.

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, MU stock was trading at $88.35. Therefore, for this article, we'll use this price.

A stock option contract on MU (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, $88.35) is above the strike price ($87.50).

So the investor would buy (or already own) 100 shares of MU stock at $88.35 and, at the same time, sell a MU Apr. 16, 2021, 87.5-strike call option. This option is currently offered at a price (or premium) of $6.30.

An option buyer would have to pay $6.30 X 100 (or $630) in premium to the option seller. This call option will stop trading on Friday, Apr. 16, 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 87.5-strike offers more downside protection than an at-the-money (ATM) or out-of-the-money (OTM) call.

Assuming a trader would enter this covered call trade at $88.35, at expiration, the maximum return would be $545, i.e., ($630 - ($88.35 - $87.50) 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 MU call option's intrinsic value is ($88.35 - $87.50) X 100, or $85.

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 $545, i.e., ($630 - $85). Extrinsic value is also known as time value.

The trader realizes this gain of $545 as long as the price of MU stock at expiry remains above the call option's strike price (i.e., $87.50).

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 a MU stock price of $82.05 (i.e., $87.50 - $5.45), excluding trading commissions and costs.

Another way to think of this break-even price is to subtract the call option premium ($6.30) from the underlying MU stock price when we initiated the covered call (i.e., $88.35).

On Apr. 16, if MU stock closes below $82.05, 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 MU 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 MU stock were to reach a new high for 2021 and close at $100 on Apr. 16, the trader's maximum return would still be $545. 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 $87.5 call before expiry on Apr. 16. Depending on her/his views and objectives regarding the underlying MU stock, s/he could consider initiating another covered call position. In other words, the trader could possibly roll out to a May 21 expiry call with an appropriate strike.

Bottom Line

MU 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 chip companies.

The exact market-timing of when MU 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 falls 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