Uncovering the Strategy: Selling Covered Calls on Nvidia

What is happening?

Tech stocks have been on a downward spiral with the Magnificent Seven shed a combined total of $950 billion in market value last Friday, the largest on record. US stocks have since extended their recovery with NVDA shares trading higher by 3.68% at $824.48 on Tuesday.

While the stocks seem to be rebounding after the Friday sell-off, swings in the prices of AI stocks continue to be uncertain. Earnings from ASML Holdings (ASML) and Taiwan Semiconductor Manufacturing Company Ltd. (TSMC) have put pressure on the semiconductor sector as they reflect trends and challenges across the broader chip industry. TSMC, a key supplier to both Nvidia and Apple, recently adjusted its growth projection for non-memory chip markets to 10%, down from more than 10%, citing potential fall in demand for consumer electronics.

For Nvidia to return to its recent peak and explore new levels, it will likely need signs from the major tech companies such as Microsoft, and Alphabet when they release Q1 earnings over the next few days. A disappointing earnings report from Meta, together with the worrying costs of AI saw its stock price taking a hit and leaving investors on edge on Wednesday. These companies are among the biggest buyers of Nvidia’s chips, but they are also developing their in-house alternatives. This creates a challenge since Nvidia requires the tech giants to maintain their investment in AI data centres that uses its chips.

What can you do?

Investors who have a long-term stake in Nvidia and believe in upside potential of the stock, even in a downward market trend for tech stocks, may consider selling call options on Nvidia. This strategy allows investors to earn premiums from the call options, which generates extra income while awaiting a rise in Nvidia's share price to their desired target.

Steps:

1. With Nvidia’s stock price at $796.77 on 25 April 2024, sell a call option with a $980 strike price (if you are comfortable selling your Nvidia shares at $980) for 1-month expiry (29 days). You will receive a total premium of $1,080,00 ($10.80 x 100 shares).
2. This gives an annualized yield of 16.8% (10.80/796.77) x (360/29).
3. If Nvidia’s price falls below $980 (strike price of the call option) at expiry, the option may expire worthless, and the investor retains the premium.
4. If Nvidia’s price rises above the strike price of $980, the investor is obligated to sell the share at $980, but the investor still retains the option premium. 

When comparing to options with longer maturity, you can observe how this alters the premium you receive and the distance over which you will be able to set the strike.

• If the investor wishes to receive more premium, the investor can go for an option with a farther expiry. For the same strike at $980, the premium increases to $12.75 as the duration increases to 36 days on 31 May 2024 (annualized yield = 16.0%).
• If the investor is only willing to sell the stock at a higher price but still want to receive same amount of premium, the investor has to choose the option with a farther expiry. For a similar premium of $10.85, you can sell the option with the strike at $1,050 and expiry in 57 days on 21 June 2024 (annualized yield = 8.6%).
• The table below shows how the premium yield changes as we adjust the strike price and expiry date. The premium yield is subject to many factors including how close the strike is to the current price as well as market moving events surrounding Nvidia. 

Annualised yield of Nvidia options with different Strike and Expiry

Advantages of covered calls

1. Generates passive income. Selling a covered call generates an income via premiums that can supplement the overall return of a portfolio.
2. Relatively low risk. As the risk of being short a call is covered with your stock position, this is a relatively low risk way to trade options.
3. No extra margin required to sell covered calls. As you hold the underlying stock for delivery, there is no extra margin required to sell the same number of covered calls at Saxo.

Risks of trading covered calls

1. Capping your stock’s upside potential. One key risk is the loss of opportunity to profit from your stock’s potential upside above the call option’s strike price.
2. Risk of using covered calls as a proxy for take profit orders: In the example above, it is possible that the stock trades well above $980 through the course of the option but on expiry falls back below $980. Without the option, the investor might have booked the profit at $980 but because the stock was covered by call options, the investor might have waited out until expiry.

Options are complex, high-risk products and require knowledge, investment experience and, in many applications, high risk acceptance. We recommend that before you invest in options, you inform yourself well about the operation and risks. In Saxo Capital Markets' Terms of Use, you will find more information on this in the Important Information - Options, Futures, Margin and Deficit Procedure. You can also consult the Essential Information Document of the option you want to invest in on Saxo Capital Markets' website.
This article may or may not have been enriched with the support of advanced AI technology, including OpenAI's ChatGPT and/or other similar platforms. The initial setup, research and final proofing are done by the author.