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Nio Covered Call: Reduce Volatility Exposure And Protect Recent Gains

Published 03/17/2021, 09:00 AM

Shares of electric vehicle (EV) companies have been red hot over the past year. Since the lows of March 2020, Tesla (NASDAQ:TSLA), which typically gets the top headlines, has returned about 550%. But with shares currently trading close to $700, investors constantly search for the next "Tesla."

Today we're taking a look at Nio (NYSE:NIO), often touted as the "Tesla of China," and provide and provide an example of how to use it for a covered call. We recently discussed how investors could consider writing covered calls on their stock holdings.

Such an option strategy could help decrease the volatility of their position and offer shareholders some protection against declines in the stock. Readers who are new to options might want to revisit that article before reading this post.


Intraday Price: $44.95
52-Week Range: $2.11 - $66.99
1-Year Price Change: Up about 1,340%

Shanghai-based Nio, founded in 2014, has been one of the early comers in Chinas premium EV market.The company designs and sells autonomous driving EVs. In September 2018, its stock went public in the U.S. as an American Depositary Receipt (ADR) at an opening price of $6.

Nio Weekly Chart.

In the two days following its listing, Nio shares hit $13.80. From that time forward until about a year ago, its fortunes were mixed at best. But significant investor appetite fueled a spectacular rally in EV and green-energy stocks since the lows of March 2020.

On Jan. 11, Nio stock hit a record high of $66.99. Since then, profit-taking has kicked in. On Mar. 5, the shares went below $32. They are down about 8% year-to-date (YTD). However, over the past week, investors have returned, pushing the stock up towards the $45 level in a matter of days. It is a highly volatile stock.

Currently, about 6.3% of all cars sold in China are EVs. Recent metrics show EVs manufactured by Warren Buffett-backed BYD Co (OTC:BYDDF) (OTC:BYDDY)) lead the market. Tesla sales follow, then Volkswagen (DE:VOWG_p) (OTC:VWAGY)), SAIC Motor Corp (SS:600104) and General Motors (NYSE:GM).

Nio announced fourth quarter and full year 2020 results on Mar. 1. The group currently sells its three car models exclusively in China. In Q4, it delivered 17,353 vehicles. For 2020, the total number of deliveries was 43,728. A year ago it was 20,565.

Vehicle sales came in at $946 million, an increase of 130% from Q4 2019. Revenue was $1 billion, up 133% year-over-year (YoY). Adjusted non-GAAP net loss of $203.2 million translated into a net loss of 14 cents per diluted share. The loss was wider than expected. Cash and equivalents were $6.5 billion as of Dec. 31, 2020.

The strong momentum has continued in 2021 as we achieved a historic monthly delivery of 7,225 vehicles in January and a resilient delivery of 5,578 vehicles in February, representing strong 352% and 689% year-over-year growth, respectively,” said Nio chief executive William Bin Li.

However, there is currently a global chip shortage. Thus, the company warned that in Q2 it would have to cut its monthly production capacity from 10,000 vehicles to 7,500 vehicles. This uncertainty has contributed to the recent volatility in NIO stock.

Coupled with investors’ nervousness regarding rising U.S. Treasury yields, a search for safer investments might be in the cards in the coming weeks. Against such a backdrop, a covered call could be appropriate for some Nio investors.

Covered Calls On NIO Stock

For every 100 shares held, the strategy requires the trader to sell one call option with an expiration date at some time in the future.

Intraday Tuesday, NIO stock was trading at $44.95. Therefore, for this article, we'll use this price.

A stock option contract on Nio is the option to buy (or sell) 100 shares.

Investors who believe there could be short-term profit-taking soon might use a slightly in-the-money (ITM) covered call. A call option is ITM if the market price (here, $44.95) is above the strike price ($44.0).

So the investor would buy (or already own) 100 shares of Nio at $44.95 and, at the same time, sell a NIO Apr. 16, 2021, 44-strike call option. This option is currently offered at a price (or premium) of $4.85.

An option buyer would have to pay $4.85 X 100 (or $485) as a premium to the option seller. This call option will stop trading on Friday, Apr. 16, 2021.

This premium amount belongs to the option writer (seller) no matter what happens in the future, for example, on the day of expiry. The 44-strike offers more downside protection than an at-the-money (ATM) or out-of-the-money (OTM) call.

Assuming a trader would enter this covered call trade at $44.95, at expiration, the maximum return would be $390, i.e., $485 - (($44.95 - $44.0) X 100), excluding trading commissions and costs.

Risk/Reward Profile For Unmonitored Covered Call

An ITM covered call's maximum profit is equal to the extrinsic value of the short call option.

The intrinsic value would be the tangible value of the option if it were exercised now. Thus, our NIO call option's intrinsic value is ($44.95 - $44.0) X 100, or $95.

The extrinsic value, on the other hand, is the difference between the market price of an option (or the premium) and its intrinsic price. In this case, the extrinsic value would be $390, i.e., ($485 - $95). Extrinsic value is also known as time value.

The trader realizes this gain of $390 as long as the price of NIO stock at expiry remains above the call option's strike price (i.e., $44).

On expiration day, if the stock closes below the strike price, the option would not get exercised, but would instead expire worthless. Then, the stock owner with the covered call position gets to keep the stock and the money (premium) s/he was paid for selling the option.

At expiration, this trade would break even at a NIO stock price of $40.10 (i.e., $44.0 - $3.90), excluding trading commissions and costs.

Another way to think of this break-even price is to subtract the call option premium ($4.85) from the underlying Nio stock price when we initiated the covered call (i.e., $44.95).

On Apr. 16, if NIO stock closes below $40.1, the trade would start losing money within this covered call setup. Therefore, by selling the covered call, the investor has some protection against a potential loss in the case of a decline in the underlying shares. In theory, a stock's price could drop to $0.

What If Nio Stock Reaches A New All-Time High?

As we have noted in earlier articles, such a covered call would limit the upside profit potential. The risk of not participating in Nio stock's potential appreciation fully would not appeal to everyone. However, within their risk/return profiles, others might find that acceptable in exchange for the premium received.

For example, if Nio shares were to reach a new high for 2021 and close at $70 on April 16, the trader's maximum return would still be $390. In such a case, the option would be deep ITM and would likely be exercised. There might also be brokerage fees if the stock is called away.

As part of the exit strategy, the trader might also consider rolling such a deep ITM call option. The trader would potentially buy back the 44 call before expiry on Apr. 16. Depending on her/his views and objectives regarding the underlying NIO stock, s/he could consider initiating another covered call position. In other words, the trader could possibly roll out to a May 21 expiry call with an appropriate strike.

Bottom Line

Nio stock has been on fire over the past year, and long term, many analysts are bullish on the company’s prospects. However, given the recent significant gains as well as the volatility in broader markets, Nio stock may take a pause as we end Q1. Wild swings in price might be accompanied by sideways consolidation.

The exact market-timing of when NIO shares could take a breather is difficult to determine, even for professional traders. But options strategies provide tools that might prepare for sideways moves or even falls in price, especially around the earnings release date.

We regard covered call options as a potential way to earn additional income from your stock portfolio. Such a strategy also helps lower portfolio volatility. Interested investors might consider increasing their knowledge base.

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