Is the AI Bandwagon Running Out of Gas?
One year ago, I explained how you could make a 400% return in just six months. The gist of that article was simple. I believed semiconductor stocks were oversold and likely to rebound strongly during the first half of 2023.
For that reason, I recommended buying a call option on the SPDR S&P Semiconductor ETF (XSD). A call option increases in value when the price of the underlying security goes up.
The timing of that advice was just about perfect. The day after that article was published, XSD bottomed out below $147. Two months before that option expired in April, XSD was trading above $200.
Since the strike price of that option trade was $150, our trade had over $50 of intrinsic value at that time. And since there were still two months to go until it expired, it also had a lot of time premium added to its price.
It didn’t hurt that NVIDIA (NSDQ: NVDA) is one of the top holdings of this fund. During the past year NVIDIA’s share price has more than tripled.
And since Wall Street was buying up anything that looked like NVIDIA, the fund’s other holdings also rose, too. Three months ago, XSD topped out near $230.
But since then, hawkish monetary policy and a skittish bond market have sent stock prices lower. Especially tech companies, which are particularly sensitive to interest rates.
Two weeks ago, XSD traded below $190 for the first time since May. Soon, it may test its technical support near $180. I expect it to bounce off that price later this year before mounting a rally next year.
If I turn out to be right about that, then repeating last year’s trade is one way to play it. Last week while XSD was trading near $190, the call option that expires on April 19 at that strike price could be bought for $21.
For the intrinsic value of that trade to exceed the cost of making the trade, XSD must rise above $211 within the next six months. Bear in mind, it was trading above that price as recently as nine weeks ago.
However, there is more risk to this trade than last year’s version. Twelve months ago, Wall Street had not yet jumped on the ChatGPT bandwagon.
That all changed around the start of this year when NVIDIA raised its guidance for revenue based on the emerging popularity of artificial intelligence (AI). Suddenly, everyone wanted a piece of the action.
For that reason, I expect the next rally in semiconductor stocks to be more muted than this year’s surge. It will a lot harder for NVIDIA triple in value again now that everyone knows about it.
For that reason, I don’t expect XSD to appreciate as much this time as it did last time. And if the Fed is serious about keeping interest rates “higher for longer,” then XSD may have trouble breaking out of its current trading range.
In that case, selling a call option may be a better idea than buying one. As long as XSD doesn’t rise above $211 by the time that call option expires, that trade would be profitable.
Two Ways to Profit
There is a way to make this trade even more profitable. You could also sell a put option at the same time with the same strike price and expiration date (a put option increases in value when the price of the underlying security goes down).
Last week, that option could be sold for $15. If XSD doesn’t drop below $175 by the expiration date, then it would also be profitable.
This type of trade is known as a “short straddle.” It is a bet that the price of the underlying security will not move very far from its current share price.
Since you would have collected $36 per share for sale of both options, XSD must either rise above $226 or fall below $154 by April for this trade to lose money.
If its share price remains within those boundaries, then this trade will be profitable. For example, let’s assume that XSD only makes it to $200 by the options’ expiration date.
In that case, your call option premium would decline in value by $10 ($200 expiration price minus the $190 strike price). However, your put option premium would lose no value. In total, you would retain $26 per share of the original $36 per share collected.
By the way, if XSD drops to $180 by expiration then your profit on this trade would be the same. Your put option trade could decline in value by $10, while your call option would not lose anything.
Yes, this type of trading can be somewhat complicated at first. However, it can also be quite profitable once you get the hang of it.
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