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Concerned About Volatility In AbbVie Stock? Try A 'Poor Person's Covered Call'

By Investing.com (Tezcan Gecgil/Investing.com )Stock MarketsSep 08, 2021 13:45
ng.investing.com/analysis/concerned-about-volatility-in-abbvie-stock-try-a-poor-persons-covered-call-91011
Concerned About Volatility In AbbVie Stock? Try A 'Poor Person's Covered Call'
By Investing.com (Tezcan Gecgil/Investing.com )   |  Sep 08, 2021 13:45
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Leading pharma group AbbVie (NYSE:ABBV) issued robust Q2 metrics in late July. However, since then, ABBV stock has been volatile. Between July 30 and Aug. 10, the shares initially declined from almost $120 to $113.

Then on Sept. 1, ABBV stock hit a multi-year high of $121.53. But the same day, it saw an intraday low of $106.10. Yesterday, AbbVie shares closed pennies above $109.

AbbVie Weekly Chart.
AbbVie Weekly Chart.

The reason behind the sell-off was a new requirement by the Food and Drug Administration (FDA) for several biopharma names to add a heart-risk warning on the label of three drugs used in arthritis treatment. It concerned AbbVie’s Rinvoq as well as separate drugs manufactured by Pfizer (NYSE:PFE) and Eli Lilly (NYSE:LLY).

Despite the recent decline in price, ABBV stock is up about 18% over the past 12 months. Its current price supports a dividend yield of 4.80%, and the market cap stands at $192.2 billion.

Next Move In ABBV Stock?

Among 24 analysts polled via Investing.com, AbbVie shares have an “outperform” rating, with an average 12-month price target of $125.19. Such a move would imply an increase of about 15% from the current level. The target range is between $105 and $144.

Abbvie Consensus Estimates.
Abbvie Consensus Estimates.

In other words, Wall Street is optimistic for the next move in ABBV stock despite the recent regulatory woes. In Q2, net revenue was $13.96 billion, up 33.9% on a reported basis. AbbVie’s drug portfolio has significant exposure to oncology and immunology. Its leading drug, Humira, represents close to half of the profits.

Thus, a number of investors might consider buying the stock for their long-term portfolios. But investing in 100 shares of Abbie stock would cost around $10,872 now, a considerable investment for most people.

Meanwhile, others could still be nervous about how far the stock could potentially fall before making a new bull leg up. Therefore, some investors might prefer to put together a "poor person's covered call" on the stock instead.

So, today we introduce a diagonal debit spread on ABBV by using LEAPS options, where both the profit potential and risk are limited. Such a strategy could be used to replicate a covered call position at a considerably lower cost, and also help decrease the portfolio volatility.

Investors who are new to options might want to revisit our previous articles on LEAPS options (for example, here and here) first before reading further.

Diagonal Debit Spread On ABBV Stock

Current Price: $108.72

A trader first buys a “longer-term” call with a lower strike price. At the same time, the trader sells a “shorter-term” call with a higher strike price, creating a long diagonal spread.

Thus, the call options for the underlying stock have different strikes and different expiration dates. The trader goes long one option and shorts the other to make a diagonal spread.

In this strategy, both the profit potential and risk are limited. The trader establishes the position for a net debit (or cost). The net debit represents the maximum loss.

Most traders entering such a strategy would be mildly bullish on the underlying security. Instead of buying 100 shares of ABBV, the trader would buy a deep-in-the-money LEAPS call option, where that LEAPS call acts as a “surrogate” for owning the stock.

For the first leg of this strategy, the trader might buy a deep in-the-money (ITM) LEAPS call, like the ABBV Jan. 20, 2023, 90-strike call option. This option is currently offered at $21.17. It would cost the trader $2,117 to own this call option that expires in less than one and a half years instead of $10,872 to buy the 100 shares outright.

The delta of this option is close to 80. Delta shows the amount an options price is expected to move based on a $1 change in the underlying security.

If ABBV stock goes up $1 to $109.72, the current option price of $21.17 would be expected to increase by approximately 80 cents, based on a delta of 80. However, the actual change might be slightly more or less depending on several other factors that are beyond the scope of this article.

For the second leg of this strategy, the trader sells a slightly out-of-the-money (OTM) short-term call, like the ABBV Nov. 19, 2021, 110-strike call option. This options current premium is $3.45. The option seller would receive $345, excluding trading commissions.

There are two expiration dates in the strategy, making it quite difficult to give an exact formula for a break-even point in this trade. Different brokers might offer “profit-and-loss calculators” for such a trade setup.

Calculating the value of the back-month option (i.e., LEAPS call) when the front-month (i.e., the shorter-dated) call option expires requires a pricing model to get a “guesstimate” for a break-even point.

Maximum Profit Potential

The maximum potential is realized if the stock price is equal to the strike price of the short call on its expiration date. So the trader wants the ABBV stock price to remain as close to the strike price of the short option (i.e., $110 here) as possible at expiration (on Nov. 19, 2021), without going above it.

Here, the maximum return, in theory, would be about $416 at a price of $110 at expiry, excluding trading commissions and costs. (We arrived at this value using an options profit-and-loss calculator).

Without the use of such a calculator, we could also arrive at an approximate dollar value. Lets take a look:

The option seller (i.e., the trader) received $345 for the sold option. Meanwhile, the underlying ABBV stock increased from $108.72 to $110. This is a difference of $1.28 per share of ABBV, or $128 for 100 shares.

Because the delta of the long LEAPS option is taken as 80, the value of the long option will, in theory, increase by $128 X 0.8 = $102.40. However, in practice, it might be more or less than this value. There is, for example, the element of time decay that would decrease the price of the option. Meanwhile, changes in volatility could increase or decrease the option price as well.

The total of $345 and $102.40 comes to $447.40. Although it is not the same as $416, we can regard it as an acceptable approximate value.

Understandably, if the strike price of our long option had been different (i.e., not $90.00), its delta would have been different, too. Then, we need to use that delta value to arrive at the approximate final profit or loss value.

Here, by not investing $10,872 initially in 100 shares of ABBV, the traders potential return is leveraged.

Ideally, the trader hopes the short call will expire out-of-the money (worthless). Then, the trader can sell one call after the other, until the long LEAPS call expires in about a year and half.

Bottom Line On ABBV Stock

For AbbVie, Humira its immunology product is still the top growth driver, generating revenues of close to $20 billion in 2020. However, the pharma giant will lose its U.S. patent exclusivity in 2023. Therefore, investors have been hesitant about what might happen after 2023.

We should note that Humira is still likely to boost overall growth of ABBV stock. The company also has a strong pipeline of other drugs. So we find ABBV stock to be a solid choice for most portfolios, either as a buy-and-hold investment or as part of a trading strategy example given above.

Concerned About Volatility In AbbVie Stock? Try A 'Poor Person's Covered Call'
 

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Concerned About Volatility In AbbVie Stock? Try A 'Poor Person's Covered Call'

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