In my April 8, 2021 Skim Additional Income with Covered Calls post I disclose the use of out-of-the-money covered calls to generate additional income. In this post, I disclose my intent to once again generate income with out-of-the-money covered calls using my underlying Mastercard (MA) shares now that my covered call option contracts expired worthless on May 21.
What Is A Covered Call?
A call option gives the buyer the right, but not the obligation, to buy the underlying instrument at the strike price on or before the expiry date.
For example, on April 8, I sold 5 MA contracts (each contract equals 100 shares) with a $420 strike price and a May 21 expiry. At the time of this trade, MA shares were trading at ~$380.
In exchange for granting someone the right to acquire my underlying MA shares, I receive an option premium of $2.09/option. Since each options contract equals 100 shares and I wrote 5 contracts, I received $1045 before nominal commission (less than $16.50).
To write a Covered Call, the option writer must own a sufficient number of the underlying shares; one of the 'Core' accounts within the FFJ Portfolio holds 500 MA shares.
Extrinsic Versus Intrinsic Value
An options contract consists of extrinsic value (time premium) and intrinsic value. The value of both makes up the total value of an option's price.
The extrinsic value takes into account external factors that affect an option's price.
Extrinsic value is also commonly referred to as 'time value'. This is because the time remaining until the option expiry is one of the primary factors that affect the options premium.
Under normal circumstances, the speed at which the time value erodes increases as the expiration date approaches.
The intrinsic value of a call option is the portion of an option's price not lost or impacted due to the passage of time. It is the difference between the underlying stock price and the strike price; it only exists when the stock price exceeds the strike price.
The options contract has no intrinsic value if:
- an option's strike price and the market price are equal OR
- a call option's strike price exceeds the market price.
While a call option may have no intrinsic value, it will have extrinsic value if there is sufficient time remaining before the option expiry date.
Implied volatility is the market's forecast of a likely movement in a security's price. Investors use this metric to estimate future fluctuations of a security's price based on certain predictive factors.
Implied volatility generally increases when investors are bearish and decreases when investors are bullish. This metric does NOT predict the price direction.
If a particular stock has high volatility it means price swings are large. In contrast, a stock with low volatility means the price likely will not make broad, unpredictable changes.
The Benefit of Covered Calls
My risk is unlimited if I do not own the underlying MA shares and write call options. If I grant someone the right to acquire my MA shares at $420, for example, and MA's share price suddenly surges to $500 I face a significant loss.
If I own the underlying shares and MA's share price suddenly rises to $500, the buyer of the options contract can buy my shares at $420. I forgo the $80/share upside.
When I own MA shares, my maximum risk is a 100% loss. This is the case even if I do not employ options. In fact, my maximum potential loss is less when I employ covered calls because I collect some option premium.
When I Use Covered Calls
I invest in high-quality companies for the long-term and write covered calls merely to skim additional income. I do not want to part with the underlying shares. Therefore, I select holdings I think are overvalued and that offer reasonably attractive option premiums.
In my Skim Additional Income with Covered Calls post, I explain why I thought a $420 strike price for my MA covered calls was a conservative means by which to skim additional income.
Why Would Anyone Buy These Option Contracts?
This might seem almost like a foolproof way to generate additional income. MA is trading at ~$380, I get paid to write options contracts with a $420 strike price, the contracts expire in ~1.5 months, and I retain the underlying shares if the share price remains below the strike price. What would possess an investor to buy the $420 options contracts.
Well....no investment works as planned 100% of the time.
A buyer of this option contract may think MA's share price has the potential to rise above $420 before the option expiry date. For example, suppose the share price rises to $500. The call option buyer can exercise their option to acquire my shares at $420 anytime before the expiry. The buyer could take ownership of my shares for $210,000 and sell them on the open market for $250,000.
Within a span of ~1.5 months, the option buyer would generate a $40,000 profit on a $210,000 investment; this excludes the $1045 option premium cost and the nominal option trading fees.
Alternatively, the call buyer may decide not to take ownership of the underlying shares. The call buyer now owns contracts valued at more than $82 ($500 - $420 strike price plus a time value component) and could sell to close this position. This is an impressive return on a $2.09/option investment.
Considerations When Employing Options
As the owner of shares in high-quality companies, I invest for the long-term and spend little time monitoring stock price fluctuations. When I employ options, however, I tend to look more frequently at the positions against which I have outstanding option contracts.
I also incur fees when I place options trades. The option transaction fees from the 2 online brokers I use are reasonable and are not a significant factor when I analyze a potential option trade.
Exercise Before Expiry
Anybody employing options would be wise to consider the key difference between American and European options.
A European option may be exercised only at the expiration date of the option. However, an American option may be exercised at any time before the expiration date.
If MA's share price had risen to $500 at the beginning of May, the buyer of the MA May 21, 2021 $420 options contracts could have exercised their right to acquire my shares at $420 at the beginning of May. The option buyer has no obligation to wait until expiry.
Expiration - What To Do?
If MA's share price exceeds the $420 strike price, I expect the options to be exercised.
Everything is automatic with the brokerage firms I use. The underlying shares are withdrawn from my account and $210,000 (500 shares x $420/share) is deposited (less fees).
As it turns out, I did nothing with my MA covered calls and I let the contracts expire. Since I still own the underlying shares I can now write additional covered calls if I so choose.
New Mastercard Covered Calls
As noted earlier, on April 8th I wrote 5 MA $420 May 21, 2021 covered calls; shares were trading at ~$380. This trade generated $2.09/option before the nominal commission.
At the time of my April trade, I looked at MA's diluted EPS track record: $1.48, $2.19, $2.56, $3.10, $3.35, $3.69, $3.65 ($4.58 adjusted), $5.60 ($6.49 adjusted), $7.94 ($7.77 adjusted), and $6.37 ($6.43 adjusted) in FY2011 - FY2020. In addition, FY2021 adjusted diluted EPS estimates from 40 brokers were $8.07, $7.28 - $8.91 (mean and a low/high range).
The forward adjusted diluted PE was ~42.65 based on the ~$380 stock price and the $8.91 high guidance. MA is a great company but this valuation is, in my opinion, irrational.
Since MA's share price experiences wide swings and I do not want to risk parting with my shares, I look at strike prices that are well out-of-the-money. I chose a ~$40/share buffer between the current share price ($380) and the strike price ($420) so as not to tempt fate.
Fast forward to the present and MA has reported $1.83 in diluted EPS in Q1. In addition, the mean adjusted diluted EPS and low/high range from 35 brokers are $7.86 and $7.36 - $8.47. With shares trading at ~$373, we get a forward adjusted diluted PE of ~44 if we use $8.47 in our valuation calculation.
If I select a $405 strike price and use $8.47, the forward adjusted diluted PE is ~47.8! In this low-interest rate environment, investors are willing to pay up to acquire shares in high-quality companies. However, a ~47.8 forward adjusted diluted PE seems excessive.
A $405 strike price is ~$32 above the current ~$373 share price. MA's share price is volatile but I think this variance leaves sufficient room for MA's share price to fluctuate without breaching the strike price.
When I wrote my $420 covered calls on April 8, roughly 1.5 months were remaining until the May 21 options expiry date. If I now select a June 18, 2021 expiry and a $420 strike price for my new covered call contracts, I have but 1 month of time value. As a result, my option premium income is ~$0.21/option or ~$100 before commission (5 contracts). This is not a desirable trade so I have just written 5 contracts with a $405 strike price and a July 16 expiry. This trade has generated $2.88/share or $1440 in total before the nominal option trade commission.
Mastercard - Generate Income With Out-of-the-Money Covered Calls - Final Thoughts
In April, I wrote covered calls against 500 MA shares held in one of the 'Core' accounts within the FFJ Portfolio; these options contracts have just expired worthless.
Despite the recent share price pullback, I think MA's current valuation is still high. I see that MA's 12-month high share price is $401.50 and while the past does not dictate the future, I think there is a reasonable probability that this level will not be breached within the next couple of months. On this basis, I have selected a $405 strike price for my new covered call position.
If you are a MA shareholder, you may also wish to generate income by writing out-of-the-money covered calls.
I wish you much success on your journey to financial freedom.
Thanks for reading!
Note: Please send any feedback, corrections, or questions to [email protected].
Disclosure: I am long MA.
Disclaimer: I do not know your circumstances and am not providing individualized advice or recommendations. You should not make any investment decision without conducting your research and due diligence.
I wrote this article myself and it expresses my own opinions. I do not receive compensation for it and have no business relationship with the company mentioned in this article.