Our options trade in Tesla (TSLA - Free Report) last week has performed well, leaving us with a healthy profit. Now is an appropriate time to discuss the best way to unwind the trade, preserving as much as possible of our gains, while eliminating the chances of a quick market move dealing us a loss.
Read last week’s article about Tesla here>>
You’ll recall we bought a call butterfly, betting that the shares would continue to rally on good news into this week. Our position looks like this:
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.
As of the close on Wednesday, Tesla shares were trading $345 - aided by some good news and probably a decent amount of short covering. If the stock is still at $345 when the options expire after the close on Friday, the spread we paid $360 for will be worth $1500 – a gain of over 300%.
Our work is not quite done, however. Let’s walk through some of the possible ways we can close the trade.
First, we could simply sell our long options and buy back our shorts.
The current market prices for the options as of the close on Wednesday are:
330C $15.30 $16.10
360C $1.25 $1.34
390C $0.10 $0.17
So if we were simply to close the options in the open market, we would receive a credit of $12.72 – a profit of $912 for each spread we did.
Because the market on the 330C is so wide however, it makes more sense to try to execute the trade as a spread, offering the butterfly in a single trade at $13.00 or $13.10, which is likely (but not guaranteed) to be filled. That would bring our profit to something more like $945 per spread.
At that point, we’d simply have the cash we made and no position or risk.
But, if we think there’s no chance Tesla will trade higher than $360 before Friday afternoon, we can wait to let the 360 calls we are short expire out of the money, earning an extra $250 per spread - assuming the stock stays at $345.
If the stock goes higher, to $350 or $355, the 360 calls will still expire out of the money and our total profit will rise to between $2000 and $2500 per spread.
At this point we will still have to execute a trade to be completely closed and have no position next Monday. We need to sell our in-the-money 330 call, otherwise it will be automatically exercised and we will own 100 shares of stock over the weekend.
Assume we wait until Friday afternoon,and that the stock is trading exactly $350, and the market quote on the 330C is $19.60 bid and $20.40 offer. We could sell the 330C and collect $1960 – a nice winner. The 360 and 390 calls will be out of the money and expire worthless, although at this point it's a good idea to buy back the two 360 calls we are short if they’re offered at $0.10 or $0.20, eliminating all risk.
But there’s a better way!
In this situation, the 330C is priced at “parity” - it’s theoretical value is exactly the amount that it’s in the money - $20. It’s delta at this point is 100. Because the market bid is only $19.60, we’d be leaving money on the table if we sell that bid.
(Admittedly, $40 is a small percentage of the profit we already made on the trade, but a good trader never intentionally leaves any money on the table.*)
Instead, it makes more sense to sell 100 shares of stock at $350. This is the smarter choice for two reasons.
First, we recognize $2000 in profit rather than $1960. (We sell the stock at $350 and when we exercise the call, we’ll be buying it back at exactly $330 – a $2000 gain.)
Second, because as the owner of an option we can choose whether to exercise it or not, we are not forced to exercise the 330 call. In the unlikely (but not totally impossible) event that the stock drops below $330 in the last hour of trading, we can choose not to exercise it and instead buy back the 100 shares at a lower price in the open market, keeping the difference as additional profit.
In this case, owning the 330 call and simultaneously being short 100 shares of stock exactly replicates owing a 330 put. I'll explain why next week…
* You might have noticed that a few paragraphs before, I was willing to spend $20-40 to buy back ostensibly worthless options, whereas here, I advise against "leaving money on the table." These are very different circumstances. Buying back the 360 calls eliminates all risk, so we are actually getting something for the money, but selling a call we own at a price below parity is simply wasting money and oppurtunity. I don't mind paying small amounts to alleviate risk, even if the risk is remote, I try very hard to never give anything away.