This is a revision of a Know Your Options column from February of 2020. I wanted to revisit the concept, and then realized that the original ideas make just as much sense as they did then – though of course the prices needed a major update. For instance, the original piece referenced a market cap for Tesla (TSLA) of $140 billion. It’s more than four times that today!
Yesterday, Tesla shares declined after news about CEO Elon Musk’s unusual email to employees imploring them to continue to be wary of expenses or risk having the shares “crushed like a souffle under a sledgehammer.” (An interesting gastronomic metaphor, to say the least…)
Today those shares made up all of those losses and more, approaching new all-time highs after a research report from Goldman Sachs revealed a newly bullish stance, a bit of a mea culpa about having not been more bullish in the recent past and a price target of $780/share – or 30% higher than Wednesday’s close.
Then there’s the wildcard aspect of S&P 500 index inclusion looming later in the month that promises to add even more volatility to Tesla’s share price.
Tesla is one of the most unusual trading situations I’ve ever seen personally, and I think that means you should approach it with an abundance of caution. Sure, a lot of money is changing hands, let's just make sure it’s not leaving yours…
“The markets can stay irrational longer than you can stay liquid.”
-John Maynard Keynes
Know Your Options is generally about trades the average retail trader/investor might want to consider.
Once again, this week it’s a warning about what not to do.
Don’t speculate on the price of Tesla using options.
Occasionally you’ll see similarly extreme moves in small cap stocks, but in those cases, even when the percentage moves are large, the total amount of money trading hands is still relatively small.
In contrast, more than $100 billion worth of Tesla shares has been changing hands in single daily trading sessions. Other huge-cap stocks like Apple (AAPL) or Amazon (AMZN) often trade only 10-20% of that amount.
It’s natural for traders watching the Tesla action to find themselves wondering at some point whether there was some opportunity to buy or sell the stock as a short-term trading opportunity.
Maybe you think the latest rally represents the first steps on the way to a trillion dollar plus market cap – as some bullish analysts have predicted – or conversely, maybe you think that the current price level represents an overbought bubble that’s destined to retest the much lower levels we saw just a few short months ago.
All that price volatility must represent some potential for short term profits, right?
A problem with the current share price is that it takes $60,000 to control just 100 shares of a $600 stock. That’s a lot of money to put at risk for the average retail trader. Sure, there’s the potential for some quick profits if you’re correct about the direction, but of course there’s also the possibility that a quick adverse move will take you out of 10K, 20K…or more.
An obvious alternative to taking a position in the shares is to use options to make a leveraged directional bet. Especially if you are a net purchaser of options contracts, you could design a trade with limited risk that still has the potential for big profits if you’re correct.
Except that there’s no such thing as a “free lunch” and the options are at least as dangerous as Tesla stock right now – and many options trades are much more dangerous.
There are two issues that make trading Tesla options especially dicey right now – implied volatilities and the rate at which those implied vols are changing, commonly known as the “vol of vol.”
Thursday, the December 600 straddle with 14 days remaining to expiration is trading around $80. That’s an implied volatility of 83%.
If you though there was going to be significant volatility over the next two weeks and decided to buy a call and a put in hopes of capitalizing on it, you’d have to shell out $8,000 for a one-lot.
Believe it or not, that’s not even historically all that high for Tesla. There have been instances – especially going into earnings reports – when the straddle has traded over $200.
The January straddle with 43 days remaining - $132.
February - $170.
If that doesn’t seem terrifying to you, it should.
If you buy the straddle expecting a move in the stock – and you got it – it’s possible that you didn’t make a cent yet. If the stock drifts slowly higher, time decay will take those options lower in a hurry. The only sure-fire way for you to make money from here is for the stock to turn sharply lower, otherwise you’re going to lose somewhere between $8,000 and $17,000. On a one lot!
Let’s say you had the same reaction to the straddle that I did – that it was too expensive – so you sold it. You now have huge risk on your hands and are simply crossing your fingers and hoping for a gradual rally. If Tesla rallies to that new Goldman Sachs price target of $780/share, you’d lose $10,000 on a short December straddle . And again, that’s on a one lot trade.
Sensible portfolio managers generally won’t risk more than 5% of their capital on a single trade. That’s the biggest trade they’ll do. That means to responsibly trade a one-lot Tesla straddle for $8,000, you’d have to have liquid capital of between $160k and $320K. That's not your total investment portfolio, that's just your speculative trading capital.
Generally, the purpose of Know Your Options is to show Zacks readers new possibilities for making options trades. This situation is quite different – I’m actively trying to talk you out of a trade.
When a stock moves this much and the vols are heading toward 100%, the profitability of almost any trade becomes a crap shoot. No one knows for sure where the stock is going over any given period, so every trade is a gamble.
Who makes money? The market makers. The bid-ask spreads are so wide that virtually every retail trade is an opportunity for a market maker to take the other side and book a dollar or more of spread profit. The professionals absolutely feast on the amateurs during periods of volatilities like this.
Keynes was a brilliant economist but a lousy trader. His realizations about the sanity of the markets came from several devastating experiences in which he tried to turn his knowledge of economic principles into trading profits - and failed miserably.
I don’t want you to fall into the same trap. Despite the apparent opportunity in trading options on a stock that has been moving so much, the odds are not in your favor.
I recommend continuing to watch this fascinating game from the sidelines.
Want to apply this winning option strategy and others to your trading? Then be sure to check out our Zacks Options Trader service.