How to use a covered call strategy to buy the dip and sell the rip on Warren Buffett’s latest Taiwan Semiconductor (TSM) buy.
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Berkshire Hathaway (BRK.B) announced last quarter that it had purchased a significant stake in Taiwan Semiconductor (TSM) stock. How extensive? How about a little over 60 million shares at just under $69 per share. This equates to an outlay of approximately $4.1 billion dollars for Berkshire and famed chairman and CEO Warren Buffett.
News of the acquisition on November 15 sent TSM shares up more than 10% that day. Shares went from under $73 pre-announcement to close above $80 post-announcement. Taiwan Semiconductor has since retreated slightly to the $78 area.
Buying Taiwan Semi shares at current levels means paying almost the highest price TSM has had in months. It’s also well above the price Mr. Buffett paid for his large stake in the company.
Fortunately, a covered call option strategy offers a way to get into TSM stock at a discount close to the Buffett Buy price while positioning yourself up front as the seller of the stock at a big step up.
A covered call transaction involves buying 100 shares of the underlying stock and simultaneously selling 1 call option against those shares. It is sometimes referred to as a buy-write because it involves buying the stock and writing the call options.
In effect, you receive the premium of the sold call option to reduce the net cost of the transaction and provide a downside buffer. That’s the good part.
However, because you have a much lower initial cost to trade, your advantage is capped at the strike price of the call sold.
An example of a covered call strategy in TSM stock would be to buy stock at current prices ($78.10) and sell the $85 calls in January for $8.80 to reduce the cost of the stock purchase with the amount of the call sale.
The table below shows that the sale of the TSM Jan $85 call reduces the net purchase price by the premium received for the call sale of $8.80. This brings the net cost of the transaction to $69.30 ($78.10 minus $8.80), providing an 11.27% downside buffer to break even on the stock.
Of course there is no free lunch in the trade. The benefit is limited to the strike price of the sold covered call of $85. However, that still leaves a potential upside profit of $15.70 points ($85 short strike price minus $69.30 initial cost). This equates to a potential gain of 22.66% on the trade if the stock closes higher than $85 on the January 19, 2024 expiration date.
This trade certainly fits the Warren Buffett philosophy of be afraid when others are greedy and be greedy when others are afraid. You are willing to be a buyer of TSM stock at an 11.27% drop when others would likely get scared. You are also willing to sell TSM on a 22.66% rally while others are likely to get greedy.
In addition, TSM has a solid dividend yield of 1.83% and a low payout ratio of around 25%, which would further increase the overall return or lower the risk to the covered call trade.
Investors can use different call strikes or expiration months to sell depending on their risk/reward profile. Selling lower strike calls would yield more premium to lower the risk on the trade, but it also lowers the return.
2022 was a tough year for equities. The S&P 500 fell 19% while the NASDAQ 100 fared even worse. Fortunately, my POWR Options program returned over 50%.
Many experts expect a difficult market environment in 2023. Investors and traders who want to hedge the downtrend and still expect a realistic upside should consider an option-based covered call strategy.
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Best!
Tim Biggam
Editor, POWR Options Newsletter
TSM shares closed Friday at $78.07, up $2.34 (+3.09%). Year-to-date, TSM has gained 4.81% versus a 1.48% gain in the benchmark S&P 500 index over the same period.
About the author: Tim Biggam
Tim spent 13 years as Chief Options Strategist at Man Securities in Chicago, 4 years as Lead Options Strategist at ThinkorSwim, and 3 years as Market Maker for First Options in Chicago. He makes regular appearances on Bloomberg TV and is a weekly contributor to the TD Ameritrade Network “Morning Trade Live”. His main passion is to make the complex world of options more understandable and therefore more useful for the everyday trader. Tim is the editor of the POWR options newsletter. Read more about Tim’s background, along with links to his most recent articles.
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