Bullish On AMD, But Shares Too Expensive? Try A ‘Poor Person’s Covered Call’

Shares of semiconductor group Advanced Micro Devices (NASDAQ:AMD) hit a record high of $110.52 on Aug. 3. So far this year, AMD stock is up about 18%, and over the past 52 weeks, it has returned over 29%.

The 52-week range has been $72.50 - $110.52 and its market capitalization (cap) stands at $133 billion. By comparison, market caps of several other leading chip giants are:

• Intel (NASDAQ:INTC) - around $218 billion;
• Micron Technology (NASDAQ:MU) - $89 billion;
• NVIDIA (NASDAQ:NVDA) - $494 billion;
• Taiwan Semiconductor (NYSE:TSM) - $607 billion;
• Texas Instruments (NASDAQ:TXN) - $174 billion.

The recent catalyst for the surge in AMD stock price has been the robust Q2 metrics announced on July 27. Revenue came at $3.85 billion, almost doubling from $1.932 billion a year ago. The company reports revenue in two main segments:

• Computing and Graphics (revenue of $2.25 billion, up 65% year-over-year, YOY, due to higher client and graphics processor sales)
• Enterprise, Embedded and Semi-Custom (revenue of $1.60 billion, up 183% YOY, due to higher EPYC processor revenue and semi-custom product sales).

Non-GAAP net income of $778 million translated into earnings of 63 cents per diluted share. A year ago, the respective numbers had been $216 million and 18 cents. Free cash flow stood at a record $888 million, up from $152 million in Q2 2020.

On the results, CEO Lisa Su cited:

“We are growing significantly faster than the market with strong demand across all of our businesses. We now expect our 2021 annual revenue to grow by approximately 60 percent year-over-year driven by strong execution and increased customer preference for our leadership products.”

Analysts noted the chip group's improved performance in the data center market. Investors were delighted that operating margin doubled and profitability more than tripled YOY. Furthermore, the company downplayed the current chip shortage.

Prior to the release of results, AMD stock was hovering between $90-$91. Now, as we write on Tuesday afternoon, it is $109.76. That is a return of over 20% in a week.

Next move in AMD Stock?/h2

Among 38 analysts polled via Investing.com, AMD shares have an “outperform” rating, with an average 12-month price target of $111.73. The target range is between $74 and $169.70. In other words, given the recent surge in price, AMD stock could soon become choppy and give up some of its recent gains, before potentially making a new high.

Therefore, interested investors might consider buying the stock for their long-term portfolios, especially if there is short-term profit-taking. However, investing in 100 shares of Advanced Micro Devices stock would cost around $10,976, a considerable investment for most people.

Others could be nervous about how far the stock could potentially fall, before making a new bull leg up. Therefore, some investors might prefer to put together a "poor person's covered call" on the stock instead.

So today we introduce a diagonal debit spread on AMD by using LEAPS options, where both the profit potential and risk are limited. Such a strategy could be used to replicate a covered call position at a considerably lower cost.

Investors who are new to options might want to revisit our previous articles on LEAPS options (for example, here and here) first, before reading further.

A Diagonal Debit Spread On AMD Stock/h2

Current Price: $109.76

A trader first buys a “longer-term” call with a lower strike price. At the same time, the trader sells a “shorter-term” call with a higher strike price, creating a long diagonal spread.

Thus, the call options for the underlying stock have different strikes and different expiration dates. The trader goes long one option and shorts the other to make a diagonal spread.

In this strategy, both the profit potential and risk are limited. The trader establishes the position for a net debit (or cost). The net debit represents the maximum loss.

Most traders entering such a strategy would be mildly bullish on the underlying security—here, Advanced Micro Devices. Instead of buying 100 shares of AMD, the trader would buy a deep-in-the-money LEAPS call option, where that LEAPS call acts as a “surrogate” for owning the stock.

For the first leg of this strategy, the trader might buy a deep in-the-money (ITM) LEAPS call, like the AMD Jan. 20, 2023, 80-strike call option. This option is currently offered at $37.72. It would cost the trader $3,772 to own this call option that expires in close to one and a half years instead of $10,976 to buy the 100 shares outright.

The delta of this option is close to 80. Delta shows the amount an option’s price is expected to move based on a $1 change in the underlying security.

If AMD stock goes up $1, to $110.76, the current option price of $37.72 would be expected to increase by approximately 80 cents, based on a delta of 80.

However, the actual change might be slightly more or less depending on several other factors that are beyond the scope of this article.

For the second leg of this strategy, the trader sells an out-of-the-money (OTM) short-term call, like the AMD Oct. 15, 2021, 120-strike call option. This option’s current premium is $4.43. The option seller would receive $443, excluding trading commissions.

There are two expiration dates in the strategy, making it quite difficult to give an exact formula for a break-even point in this trade. Different brokers might offer “profit-and-loss calculators” for such a trade setup.

Calculating the value of the back-month option (i.e., LEAPS call) when the front-month (i.e., the shorter-dated) call option expires requires a pricing model to get a “guesstimate” for a break-even point.

Maximum Profit Potential/h2

The maximum potential is realized if the stock price is equal to the strike price of the short call on its expiration date. So the trader wants the AMD stock price to remain as close to the strike price of the short option (i.e., $120 here) as possible at expiration (on Oct. 15, 2021), without going above it.

Here, the maximum return, in theory, would be about $1,196 at a price of $120 at expiry, excluding trading commissions and costs. (We arrived at this value using an options profit-and-loss calculator).

Without the use of such a calculator, we could also arrive at an approximate dollar value. Let’s take a look:

The option seller (i.e., the trader) received $443 for the sold option. Meanwhile, the underlying AMD stock increased from $109.76 to $120.00. This is a difference of $10.24 per share of AMD, or $1,024 for 100 shares.

Because the delta of the long LEAPS option is taken as 80, the value of the long option will, in theory, increase by $1,024 X 0.8 = $819.20 (However, in practice, it might be more or less than this value.)

The total of $443 and $819.20 comes to $1,262.20. Although it is not the same as $1,194, we can regard it as an acceptable approximate value.

Understandably, if the strike price of our long option had been different (i.e., not $80.00), its delta would have been different, too. Then we need to use that delta value to arrive at the approximate final profit or loss value.

Here, by not investing $10,976 initially in 100 shares of AMD, the trader’s potential return is leveraged.

Ideally, the trader hopes the short call will expire out-of-the money (worthless). Then, the trader can sell one call after the other, until the long LEAPS call expires in about a year and half.

Bottom Line

Active position management in a diagonal debit spread is typically more difficult for novice traders. If AMD is above $120 on Oct. 15, the position will make less than the potential maximum return as the short-dated option will start losing money.

Then, the trader might feel the need to close the trade early if the price shoots up and the short call gets caught deep ITM.

In future weeks, we will continue our discussion with different examples of options strategies.

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Written By: Investing.com