Stock prices of publicly traded technology companies have been resilient this year. Many remained unaffected or benefited from the onset of the current crisis.
Other sectors seem more exposed to uncertainty and economic downturns. Despite lofty valuations and recent turmoil, many investors remain hesitant to rotate out of technology stocks.
An available alternative is to take profits by selling call options against existing positions. The premium received reduces the position cost base and risk.
The strategy is known as a covered call. It can also be established as a new position, by purchasing stocks and simultaneously selling options for the same number of shares acquired.
General impact
- The stock cost basis is reduced by the amount of premium received.
- Cash is released.
- The maximum combined payout at expiration is the strike. The strike is always above the current price of the stock minus the premium. Upside remains from the net cost up to the strike of the option sold.Covered calls are less volatile than underlying stocks. Stock price movements are partially counterbalanced by premium value changes
- Drawbacks are a capped upside and unprotected downside below the strike.
Technology stocks option prices
The sector stocks volatility and option premiums are high.
Technology stock prices are expected to move faster when rising, with a tendency to “melt up” from improved growth prospects and increased demand for shares.
High strike options on the call side have increased demand, as the options provide leveraged exposure to upward stock price movements.
The above factors make high strike options premiums expensive when compared to lower strike options.
Call option premiums
| (1) Premium | (2) Premium | (3) Premium | (4) Premium | ||
| Company | Ticker | three-month | one year | one year | one year |
20% |
20% |
||||
| at the money | at the money | out of the money | in the money | ||
| Apple Inc. | AAPL | 9.5% | 14% | 9% | 28% |
| Tesla, Inc. | TSLA | 17.5% | 30.5% | 25% | 38% |
| Amazon.com, Inc. | AMZN | 9.5% | 16% | 9% | 26.2% |
| Microsoft Corporation | MSFT | 8% | 13.5% | 7% | 25% |
| Facebook, Inc. | FB | 9% | 16% | 7.3% | 26% |
| Netflix, Inc. | NFLX | 10.2% | 17% | 10% | 28% |
Data source: Yahoo! Finance
Three-month at the money premiums are usually about half of those for one year at the money options. Current prices exceed that yardstick.
The extra premium reflects nearing US elections, a potential second pandemic wave and associated economic uncertainties.
Different strategy implementations
Below I analyze the impact of choosing three different strikes and expirations.
1. Three month at the money
The premium collected is more than half of that of an at the money one-year option. Depending on the underlying stock, the cushion built by the strategy is anywhere from 8% (MSFT) to 17.5% (TSLA) of the stock price. (Table column 1).
The strategy takes advantage of the relative valuation of short-term options.
Lower strikes in the same expiration have reduced net premiums. Higher strikes are better priced and leave more room for upside.
2. One year in the money
A conservative use of the strategy.
In the money options have two components, the difference between the strike and the current market price (“the intrinsic value”) and the pure optional value (the “time value”).
Time value of 20% in the money covered calls is just below that of three-month at the money options. Setting the strikes 20% below the current market price provides downwards protection. The strategy generates a net cushion ranging anywhere from 25% (MSFT) to 38% (TSLA). (Table column 4).
The main benefit is a large cushion. A drawback is the longer time to expiration, for a reduced premium. In addition, low strike options are priced less attractively than high strike ones on a relative basis.
3. One year out of the money
The choice of strike capitalizes on the sizeable premiums of high strike options.
The strategy leaves room for upside up to the strike of the option sold. It is best suited as a “repricing” of the stocks that frees cash – capping in exchange the upside of the position.
Depending on the underlying stock, the cushion built by the strategy is anywhere from 8% (MSFT) to 17.5% (TSLA) of the stock price. (Table column 3).
Disclosure: I hold a long position in Amazon (AMZN).
