Last week in Know Your Options, we discussed a strategy for rolling covered calls to a higher strike in a more distant expiration cycle in stocks that have been performing well to enhance profits in the trade. Readers wanted to know about the mechanics of the covered call trade in general, so this week we’ll take a look at how to choose candidates for covered calls (also known as a “buy-write”) based on momentum in the stock and implied volatility in the options.
You’ll recall that maximum profits in hedged options trades come when the share price moves to the strike of options we’ve sold. Ideally with a covered call – in which we buy shares of stock and sell out of the money calls at a one-to-one ratio – the stock price climbs steadily to the strike of the short calls, giving us maximum profit on the stock position while still allowing us to retain the entire option premium we collected.
We want a stock with positive upward momentum and high implied option volatilities to maximize the premium received.
Advanced Micro Devices (AMD - Free Report) fits the bill.
Though it’s a Zacks Rank #3 and trades at a 12 month forward P/E ratio of almost 60X – a huge multiple of the forward P/E ratio of close competitor Intel Corp (INTC - Free Report) at 12X - AMD shares have definitely been on a hot streak lately, rising from $11/share at the beginning of 2018 to close at $28.51/share on Wednesday. Momentum was further confirmed on Wednesday as the stock eked out a 1.6% gain on a day when most tech stocks performed poorly.
Option volatilities are high as traders have been purchasing calls all year and rolling them up to higher strikes as the shares rallied. Options market makers typically raise their estimates for implied vols in the event of higher market demand and the AMD September 30 strike calls which have only 15 days to expiration are trading $1.25 – that’s a 77.5% implied volatility!
The volatility skew is also in our favor as the 30 calls have a higher implied vol than the at-the-money options, which is uncommon but is the result of market demand. That’s exactly the type of option we want to sell.
We can buy this popular momentum stock at $28.50 and sell the SEP 30 calls at $1.25 and set up a trade with excellent p/l profile.
If the stock stays here or rallies but to less than $30/share before expiration, we will have purchased it at $27.75. If the stock were to rally through the 30 strike, it will be called away at expiration and we’ll book a quick and easy profit of $2.75/share.
Of course, as is the case with any stock, there’s also some chance the shares will decline between now and expiration, but even in that scenario, we have an extra $1.25 in profit from the calls we sold to mitigate the loss.
When we combine good momentum with high implied volatilities - and also are willing to take the opposite side of the options trade from the prevailing crowd - we can design ourselves a position with a good chance of booking a quick profit while taking less risk than simply owning the shares outright.