SNAP Covered Call: One Way To Limit The Volatility Of A Momentum Stock

In the social media space, Snap faces competition from Facebook (NASDAQ:FB), Twitter (NYSE:TWTR), Pinterest (NYSE:PINS), as well as TikTok—a subsidiary of Chinese parent-company ByteDance, whose ecosystem extends far beyond TikTok.

In 2014, Facebook wanted to acquire Snap for $3 billion, but the group declined the offer. Then Snap had its stock market debut in March 2017 at an IPO price of $17.

The company is expected to release Q1 earnings in late April. Therefore, today, we look at Snap and provide the example for a covered call on the company's shares.

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 potential 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.

Intraday Price: $57.15
52-Week Range: $11.32 - $73.59
1-Year Price Change: Up about 370%

California-based Snap announced Q4 and full-year 2020 results at the beginning of February. Quarterly revenue increased 62% year-over-year (YoY) to $911 million. Daily active users (DAUs) were 265 million in Q4 2020, an increase of 47 million, or 22% YoY. Investors were pleased with the robust revenue and user growth.

Non-GAAP net income was $136.1 million versus $41.9 million in Q4 2019. Diluted non-GAAP EPS came in at 9 cents. A year ago, it was 3 cents. Cash and equivalents stood at $2.5 billion.

CEO Evan Spiegel said:

“We are proud of the strong results we delivered for our advertising partners this quarter and over the full year. We delivered our first full year of adjusted EBITDA profitability and, as we look towards the future, we are excited to build on our investments in augmented reality, mapping and content to drive our ongoing growth.”

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In Q1 2021, management expects revenue to be between $720-$740 million, compared to $462 million in Q1 2020. Snap stock’s P/B and P/S ratios are 35.32 and 31.44, respectively. Given the massive increase in the Snap share price during the past 12 months as well as the frothy valuation, there could be volatility with a downward bias around the upcoming earnings release date. Thus, a covered call 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 of this writing intraday Tuesday, Snap was trading at $57.15. Therefore, for this post, we'll use that price.

A stock option contract on SNAP (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, $57.15) is above the strike price ($55.00).

So, the investor would buy (or already own) 100 shares of SNAP stock at $57.15 and, at the same time, sell a SNAP May 21, 2021, 55.00-strike call option. This option is currently offered at a price (or premium) of $6.75.

An option buyer would have to pay $6.75 X 100 (or $675) 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 55.00-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 $57.15, at expiration, the maximum return would be $460, i.e., ($675 - ($57.15 - $55.00) 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 SNAP call option's intrinsic value is ($57.15 - $55.00) X 100, or $215.

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 $460, i.e., ($675 - $215). Extrinsic value is also known as time value.

The trader realizes this gain of $460 as long as the price of SNAP stock at expiration remains above the call option's strike price (i.e., $55.00).

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 SNAP stock price of $50.40 (i.e., $57.15 - $6.75), excluding trading commissions and costs.

Another way to think of this break-even price is to subtract the call option premium ($6.75) from the underlying SNAP stock price when we initiated the covered call (i.e., $57.15).

On May 21, if SNAP stock closes below $50.40, 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 SNAP 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 SNAP stock were to reach a new high for 2021 and close at $80 on May 21, the trader's maximum return would still be $460. 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 $55.00 call before expiry on May 21.

Depending on her/his views and objectives regarding the underlying SNAP 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

SNAP stock has been on fire over the past year, and long term, we are bullish on the company. With a market capitalization around $83 billion, the social media platform has further room for growth. However, earnings season typically means increased volatility for such momentum shares. The initial reaction to tech stocks’ earnings can easily be “not strong enough” past quarter or guidance.

The exact market-timing of when SNAP 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