Smart Investor: improve your returns on Tesla with covered calls

Covered Calls Strategy

Covered calls involve selling call options on a stock that you already own. This strategy allows you to generate additional income through the premiums received. For more details on how covered calls can enhance your portfolio performance, please refer to my earlier article: Using Covered Calls to Enhance Portfolio Performance.

Tesla Options Analysis

Analyzing Tesla’s options chain as of July 5th, we can identify potential covered call opportunities. Key factors to consider include expiries, strike prices, and implied volatility. Here is an overview of the available expiries for Tesla options:

Selection Criteria for Covered Calls

When selecting expiries and strikes for selling covered calls, consider the following criteria:

1. Premium Received:

   • Higher premiums can provide better income but come with higher risk. The premium received should align with your income goals. For instance, if your target is a 1% return per month, which is approximately $2.50 (current price of Tesla divided by 100), you need to search for calls that pay at least $2.50 in premium.
      

2. Probability of Being In-The-Money:

   • Strikes closer to the current stock price have a higher probability of being exercised. If you aim for a high probability of achieving your target without frequent monitoring, select strikes that provide the desired premium while considering the likelihood of the stock reaching that strike price. 
     
     

3. Risk Tolerance:

   • Balance the potential income with the risk of losing your shares if the options are exercised. Consider how comfortable you are with the risk of assignment and how it fits with your overall investment strategy.
      

4. Volatility Considerations:

   • It's essential to consider the potential volatility spike around the earnings date on July 23rd, as this can significantly impact option premiums and the likelihood of the calls being exercised.

Below are a couple examples which illustrate how you could make strike and expiry selections based on the above criteria.

Selection Examples:

1. Based on Premium Received:

   • If you want to receive approximately 1%, you should look for strikes and expiries with a bid price of around $2.50 (which is the underlying stock price divided by 100).
      

   Examples:

   • 12-July-2024 Expiry (7 days): Strike $270, Premium ~$2.50
   • 19-July-2024 Expiry (14 days): Strike $285, Premium ~$2.50
   • 26-July-2024 Expiry (21 days): Strike $320, Premium ~$2.50
   • 02-August-2024 Expiry (28 days): Strike $330, Premium ~$2.50
   • etc...
      

2. Based on Probability:

   • If you want an 80% probability of the options expiring worthless, you should look for strikes and expiries with a delta of around 0.2.
      

   Examples:

   • 12-July-2024 Expiry (7 days): Strike $272.5, Delta ~0.19, Premium ~$2.11
   • 19-July-2024 Expiry (14 days): Strike $280, Delta ~0.20, Premium ~$3.00
   • 26-July-2024 Expiry (21 days): Strike $300, Delta ~0.19, Premium ~$4.25
   • 02-August-2024 Expiry (28 days): Strike $305, Delta ~0.19, Premium ~$4.70
   • 09-August-2024 Expiry (35 days): Strike $310, Delta ~0.20, Premium ~$5.25
   • 16-August-2024 Expiry (42 days): Strike $315, Delta ~0.20, Premium ~$5.45
   • etc...
      

3. Based on Risk Tolerance and Technical Analysis:

   • Use technical analysis to determine price levels that you think Tesla won't reach, and pick an expiry and strike price above those technical targets. This approach helps you set more informed and confident strike prices based on market behavior.
      

   Examples:

   • If your technical analysis suggests Tesla won't exceed $275 before the earnings-date, you might choose a strike price of $275 or higher, with an expiry of 14 days (19-jul-2024).
   • Select an expiry that aligns with your risk tolerance, ensuring it provides a sufficient premium and fits within your engagement level.

Understanding the Risks

Always remember that there is risk involved in selling covered calls. The main risk with covered calls is that if the stock price rises significantly above the strike price, you could miss out on potential gains since your shares may be called away at the strike price, which is below the market price. Additionally, while you receive a premium for selling the call, the premium might not fully offset the potential opportunity cost of having your shares called away. Generally, higher premiums correspond to higher risk, as they are often associated with higher volatility and greater uncertainty about future stock price movements. It's crucial to balance the income received from premiums with your risk tolerance and overall investment strategy.

Conclusion

By considering your income goals, probability of being in-the-money, and risk tolerance, you can select the most suitable expiries and strikes for your covered call strategy. This approach helps you balance potential returns with the risks and effort involved in monitoring your positions.