How To Use A Covered Call To Protect Recent Tilray Gains

Canadian medical cannabis supplier Tilray (NASDAQ:TLRY) announced Q4 and FY20 financial results on Feb. 17. Following the release, TLRY shares have been volatile and come under pressure.

We recently discussed in detail how investors might consider writing covered calls. Readers who are new to options might want to revisit that article before reading this post.

Today, we'll look into using an options strategy with Tilray stock. This piece should help increase the reader's understanding of options. For more experienced investors, it is likely to offer ideas for future trades.

Tilray

• Current Price: $23.55
• 52-Week Range: $2.43 - $67.00
• 1-Year Price Change: Up about 19.6%

Tilray has recently been making headlines following the announcement on Dec. 16 that it will merge with another cannabis manufacturer, Aphria (NASDAQ:APHA) (TSX:APHA).

The combined entity will become the largest cannabis company based on pro forma revenue. When the transaction completes, possibly in the second quarter of 2021, the combined company will trade on the NASDAQ under the ticker symbol TLRY.

Following the news of the proposed merger, TLRY shares hit a 52-week high of $67. Now, they are hovering at $23.55.

Tilray Weekly Chart.

According to the latest financial metrics, total revenue increased to $56.6 million, up 20.5% year-over-year (YoY). The company divides income into two main segments—cannabis (up 46%) and hemp (down 18%).

The cannabis segment is further made up of:

• International medical (up 191%);
• Canadian adult-use (up 49%);
• Canadian medical (up 26%).

In Q4, net loss was $3 million, or a loss of 2 cents per share. A year ago, the net loss had been $219.8 million, or $2.14 a share. Cash and equivalents totalled $189.7 million at the end of the quarter.

Meanwhile, Reddit members have also been paying increased attention to TLRY stock. Investing.com readers would well remember how recent moves by Reddit traders as well as retail investors have affected the share prices of GameStop (NYSE:GME) and AMC Entertainment (NYSE:AMC).

Given the increased volatility in TLRY stock as well as the potential for further profit-taking, a covered call might be an appropriate strategy for some investors, especially those who might want to protect some of their recent gains without selling their Tilray holdings.

Covered Calls On TLRY 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.

As we write, Tilray stock is trading at $23.55. A stock option contract on TLRY (or any other stock) is the option to buy (or sell) 100 shares.

Investors who believe there could be further 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, $23.55) is above the strike price.

So the investor would buy (or already own) 100 shares of Tilray stock at $23.55 and, at the same time, sell a TLRY April 16, 2021, $22-strike call option. This option is currently offered at a price (or premium) of $6.13.

An option buyer would have to pay $6.13 X 100 (or $613) in premium to the option seller. This call option will stop trading on Friday, April 16, 2021.

The $22-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 $23.55, at expiry, the maximum return would be $458, i.e., ($6.13 - ($23.55-$22.00)) 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 TLRY call option's intrinsic value is ($23.55-$22.00) X 100, or $155.

The extrinsic value 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 $458, i.e., ($613-$155). Extrinsic value is also known as time value.

The trader realizes this gain of $458 as long as the price of TLRY stock at expiry remains above the strike price of the call option (i.e., $22.00).

At expiration, this trade would break even at a Tilray stock price of $17.42 (i.e., $22-$4.58), excluding trading commissions and costs.

Another way to think of this break-even price is to subtract the call option premium ($6.13) from the underlying TLRY stock price when we initiated the covered call (i.e., $23.55).

On April 16, if TLRY stock closes below $17.42, the trade would start losing money within this covered call set-up. Therefore, by selling this covered call, the investor has some protection against a potential decline in the underlying shares. In theory, a stock's price could drop to $0.

What If Tilray 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 TLRY stock's potential appreciation fully would not appeal to everyone. However, within their risk/return profile, others might find that acceptable in exchange for the premium received.

For example, if Tilray stock were to reach a new record high and close at $67 on April 16, the trader's maximum return would still be $458. 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 this deep ITM call option. In that case, the trader would buy back the $22 call before expiry on April 16. Depending on her/his views and objectives regarding the underlying TLRY stock, s/he could consider initiating another covered call position. In other words, the trader could roll out to a May 21 expiry call with an appropriate strike.

Bottom Line

The exact market-timing of when TLRY shares might stop declining or start going up again is difficult to determine, even for professional traders. But options strategies provide tools that might help an investor prepare for sideways moves or even falls in price in stocks.

There are many angles involved in using various options for hedging or speculative purposes. Interested readers might consider putting in the time and effort to educate themselves further.