The recent rout in the stock market (S&P 500 down 7.8% in the 6 days ended February 2/6/2018) has caused a scramble for hedges and a spike in premiums.
Often in the midst of such turmoil, the best hedge is to sell premium.? This week, we take a look at covered call hedging opportunities offered on Micron Technology (MU), a stock that has been recently upgraded by a number of analysts.
Micron: Swings and Potential
Semi-conductor and storage technology leader, Micron Technology (MU) has seen more than its share of ups and downs these past years.? Even though it has gained more than 200% since the beginning of 2016, it still trades at a P/E ratio of about 4.75, less than a third of that of the overall market.? Still, the stock is very much influenced by swings in its industry and by ongoing uncertainty about future earnings.? It may well be a good stock to hold, but it is also one you should probably hedge. As with most stocks, recent gyrations have jacked up premiums to levels where protective puts are expensive and writing calls appears to the preferable way to hedge.
Three Covered Call Hedges
Figure 1 below compares three covered call alternatives, in-the-money, out-of-the-money and at-the-money (or close-to-the-money). For purposes of this report, base our calculations on the cost of establishing the position ? i.e., buying the stock and simultaneously selling the call.
With the stock at $42.34, the In-the-Money $39 Call is priced at $5.50 versus our model?s estimated premium of $5.19.?? Looking at the right hand column above, we see that it offers 13.0% in downside protection (breakeven of $36.84). It also offers a very attractive yield per annum of 29.3%.? The offset, of course, is that its profit potential is limited to 5.9%.? In other words, if the stock were to end up above $44.50 on 4/20/18, you would have been better off just holding the stock ? or writing a call with a higher strike price.