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A Short Squeeze Options Trade for Tesla

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It was all good news for Tesla (TSLA - Free Report) on Tuesday night as details from the annual shareholder meeting were released. Shareholders voted to retain CEO Elon Musk in his dual role as Chairman of the Board and retained all three Musk-friendly board members who were up for re-election.

Even more important was the revelation from Musk himself that the company was indeed on pace to produce 5,000 Model 3 automobiles per week by the end of June, which has been widely considered the number they need to be cash-flow and net-earnings positive in Q3.  Musk also said that after extended delays, the Gigafactory would soon be producing more batteries than all other electric automakers in the world.

Finally Tesla’s global head of sales, Robin Ren, revealed that the company has plans to build a second Gigafactory in Shanghai, China, followed thereafter by one in Europe and eventually 8-10 more worldwide.

TSLA shares rallied $28.37 or almost 10% during Wednesday’s trading session.

Three weeks ago, we detailed how a combination of short interest in TSLA’s shares and open interest in TSLA options could spur a significant short-covering rally if good news were to be released. (Read that article here>>)

The conditions that existed back then (approximately $11B in short interest, high implied option volatilities, high put/call ratio) were basically the same on Tuesday night.

After Wednesday’s action, it appears that the short squeeze is definitely on in Tesla.

Because short covering rallies cause additional pain to those shorts who didn’t cover their positions early on, they tend to last longer than a single trading session. As the share price creeps higher, more shorts are forced to buy to cover, either because of garden-variety capitulation, or at the behest of the risk managers at the firms financing the short positions.
It would therefore not be surprising to see Tesla shares continue to creep higher in over the coming days and weeks as more traders decide that they can’t stand the pain and close short positions.  

We'll want to keep our trade short-term to avoid the next earnings cycle and any other news that might derail the rally.

If the shares do continue to rise over the next few weeks, there is an options trade that has limited risk, will profit from the rally, and is priced attractively due to the high implied volatilities in Tesla calls.

The trade: Long a 330-360-390 call butterfly, expiring June 15th.
Buy 1 June 330 call @ $5.10
Sell 2 June 360 calls @ $0.90
Buy 1 June 390 call @ $0.30
Net spread price: $3.60.

The maximum loss on the trade is the $3.60 we spent in premium, which comes if the shares are lower than $330 or higher than $390 at expiration.  The maximum possible profit is $26.40, occurring if the shares are exactly at $360 at expiration, roughly 12% higher than Wednesday’s closing price.

Our break-evens are $333.60 and $386.40 at expiration.

The spread is attractively priced because the 360 calls (that we are selling two of) are priced at a much higher implied volatility (52%) than the 330 call that we’re buying (45%). Technically the 390 call has an even higher implied volatility, but the premium is so low that it’s largely inconsequential – a lower vol would only change the price a few cents.

So we have designed a spread that fits our short squeeze thesis, has limited risk, has a potential payoff of over 7 to 1, and takes advantage of the current pricing of the volatility curve to make it relatively inexpensive to enter.  If Tesla continues to grind higher, we’ll start counting our profits at $333.60.

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