Covered-call writing is an interesting way to play volatile, big-name companies with great promise but no clear direction. In that light, Twitter Inc. makes an interesting case study.
Twitter’s stock, recently priced at $36.60 (all figures are in U.S. dollars), is embroiled in a classic tug of war between equally weighted sides trying to value a great platform with minimal earnings. The result is a stock that’s exhibiting above-average volatility with no directional bias.
Normally, a covered-call strategy requires a mildly bullish view. But with Twitter, the technology is so new and changing so fast that any directional bet is, at best, a guess. And with options premiums trading in the top quartile of implied volatility, the enhanced income looks attractive.
For example, you could buy Twitter and sell the February 38 calls for a $2.60-a-share premium. The sale of at-the-money calls captures the above-average premium without having to make a significant upside bet.
If the stock closes above $38 a share at the Feb. 20 expiration, this trade returns 10.9% over seven weeks. If the stock remains the same, your client retains the shares and the $2.60 premium for a net seven-week return of 7.1%.
The premium also provides downside protection but does not remove all the risk. The $2.60-a-share premium reduces the cost of the initial shares, creating a downside break-even point at $34. That’s the reason why you should have a bullish bias behind any covered-call strategy.
So, what about a client who is bearish on the stock? The obvious choice would be simply to buy puts. The problem with this approach is the cost of the puts. If the premise behind the sale of covered calls is to capture an above-average premium, then paying up for a directional bet would seem counterintuitive – unless your client is convinced that Twitter’s management is all hype and no substance.
For a client who is less sure, you could look at “ratio call writing” to take advantage of the enhanced volatility with a slightly bearish bias. Rather than selling one call for every 100 shares, you would sell additional uncovered calls. How many additional calls rests with how strongly your client believes in the bearish case.
Let’s do some math. When you think about any strategy in which you sell uncovered calls, you have to look closely at the net delta within the strategy. (Delta tells us how much an option is expected to move, given a $1 move in the underlying stock.) At-the-money options typically have a delta of 0.5, which means they would be expected, over short periods of time, to move by 50¢ for every $1 rise or fall in the value of the underlying stock.
Another way to use delta is to calculate a net share position in a given strategy. For example, if you were to buy 100 shares of the underlying stock and sell one call with a delta of -0.5 (we attach a negative to the delta on short calls), the net result would be a net share position of 50 shares.
If your client were to sell two at-the-money calls, the net share position would be zero (i.e., long 100 shares, short two calls with a net delta of -1.0). This so-called ratio call write effectively neutralizes the overall position for short periods while capturing the enhanced income.
A word of caution, though: any strategy that involves an uncovered option requires you to monitor the position closely, as the uncovered calls in the ratio call write will be impacted negatively by any short-term rally in the price of the underlying shares.
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