Uncovering the Strategy: Selling Covered Calls on Alphabet Inc.

What is happening?

Alphabet beat expectations for its first quarter earnings, driven by strong revenue from Google search, advertising as well as its cloud computing business. Google’s parent company reported earnings of $1.89 per share on revenue of $80.5 billion, surpassing Wall Street’s estimates of $1.51 per share on revenue of $78.7 billion. Google Cloud revenue increased 28% year-over-year and came in at $9.6 billion, boosted by generative AI tools that rely on cloud services. Alphabet also announced its first-ever dividend of  20 cents per share and a $70 billion shares buyback. The CEO, Sundar Pichai said "Our leadership in AI research and infrastructure, and our global product footprint, position us well for the next wave of AI innovation."

The outlook for Alphabet is positive as its core revenue generators, online search, and advertising are performing better than expectations despite challenges posed by AI and increased competition from tech giants like Microsoft and Meta. Additionally, investment in generative AI appears to be yielding results, with strong demand and growth in their cloud computing services. Google has also initiated rounds of layoffs as part of its effort to allocate resources for AI investment. Analysts have generally responded positively to Alphabet’s Q1 results, with many revising their ratings and price targets for the stock.

What can you do?

For investors holding Alphabet for long-term investment and believe in the company’s core revenue drivers as well as upside potential from its AI investments in the long term but are worried about the overvaluations of US mega-caps in the short term, may consider selling covered call options on partial holdings of Alphabet. This strategy enables investors to earn premiums from the call options, providing additional income while they wait for Alphabet’s share price to reach their desired price target.

Illustration:

1. With GOOGL’s stock price at $168.10 on 07 May 2024, selling a call option with a $195 strike price (if you are comfortable selling your GOOGL shares at $195) for 1-month expiry (31 days) will yield a total premium of $20.00 ($0.20 x 100 shares).
2. This gives an annualized yield of 1.38% (0.20/168.10) x (360/31).
3. If GOOGL’s price stays below $195 (strike price) on 07 June 2024(expiry), the option will expire worthless, and the investor gets to keep the premium.
4. If GOOGL’s price rises above the strike price of $195, the investor is obligated to sell the share at $195, but the investor still keeps the option premium thereby making the effective selling price 195 + option premium.

Note:

1. Please note options trade in lot sizes of 100 shares. When an investor sells 1 lot of call option, they are selling a call option on 100 shares.
2. Prudent investors typically sell covered calls only on part of their holdings and keep the upside open on the rest.

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 longer expiry. For the same strike at $195, the premium increases to $0.92 as the duration increases to 73 days on 19^th July (annualized yield = 2.70%).
• If the investor is only willing to sell the stock at a higher price but still want to receive a relatively similar premium, the investor has to choose the option with a longer expiry. For a premium of $0.63, you can sell the option with the strike $215 and expiry in 101 days on 16^th August (annualized yield =1.34%).
• 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 Alphabet. 

Annualised yield of Alphabet options with different Strike and Expiry

Advantages of covered calls

• Generates passive income. Selling a covered call generates an income via premiums that can supplement the overall return of a portfolio.
• 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.
• 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

• 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.
• 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 $195 through the course of the option but on expiry falls back below $195. Without the option, the investor might have booked the profit at $195 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.