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An Option Trade for Tesla's "Make or Break" Quarter

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The third quarter of 2018 is shaping up to be one of the most crucial periods ever for electric automaker Tesla (TSLA - Free Report) as they attempt to increase the number of Model 3s they deliver to customers by 200% over Q2.

The company has said they expect to produce 50,000 – 55,000 Model 3s during the quarter and deliver even more than that - with some autos produced in Q2 also reaching customers.

Tesla delivered 18,449 Model 3s in Q2.

Tesla has ramped up production in every conceivable way, adding a third production line and running three shifts to produce the maximum number of cars. With 400,000 customers still on the waiting list for a Model 3, Tesla is still firmly in the period where they can sell essentially every car they can produce.

Though the company has not released any official production data, recent news items about transport and delivery issues would seem to suggest that they have a large number of Model 3s ready to go home with paying customers if they can solve the final few bottlenecks.

We reported on the transition from “production hell” to “delivery hell” last week.

More recently Tesla has reported difficulty arranging enough transport vehicles to bring Model 3s to sales centers to be delivered and has even asked existing Tesla owners - presumably fans of the car and the company - to volunteer over the weekend to answer questions from new owners about vehicle features. These would both seem to suggest a huge surge in deliveries might be imminent.

Assuming we do see a huge increase in deliveries in Q3 – and even 45,000 would likely be seen as a big win for the firm - we’ll also have to wait until the next quarterly earnings report for a look at the gross margins the company has been able to achieve on its first mass market offering.

Optimistic forecasts are for something near 25%, and we previously reported on an effort by a German auto magazine to reverse engineer the likely cost of materials and labor that suggested that is possible, but it remains to be seen how the recent ramp up in production will affect Tesla’s expenses.

If Tesla gets even close to it’s self-imposed goals, which would also mean they will reach profitability soon, we can expect a sharp runup in the stock. Tesla is trading well off its 52-week high of $387/share which occurred right after CEO Elon Musk’s infamous “funding secured” tweet, but also well above recent lows of $263/share earlier this month - after it was announced that the Department of Justice was investigating that tweet and its effect on Tesla shares.

Options on Tesla are fairly expensive, with November at the money implied volatilities around 63%. At high implied vols, we'd prefer to sell more options than we buy. If we want to use options to take a position on big production and delivery numbers, we can use a ratio bull call spread to reduce the cost. We’ll want to use November options because they expire after the next quarterly report which is due on November 7th.

The relevant prices as of Wednesday’s close are:

Tesla: $310/share

                                            Bid                                         Ask

NOV 350 Call                      $12.75                                   $13.10

NOV 400 Call                      $3.70                                     $3.95

If we buy one 350 call and sell two 400 calls for a debit of $5.50, we can significantly reduce the cost of gaining upside exposure while shifting the risk to the extreme upside – prices that Tesla shares have never traded.

The p/l profile looks like this:

Our max profit would be if Tesla was trading right at $400/share at expiration where we’d make $44.50. If the shares failed to rally to $350, we’d lose the entire $5.50 premium we paid. It’s important to note that this is not a limited risk trade. Our breakeven on the upside is at $450/share and we suffer losses above that. Even though that’s higher than the shares have ever traded and represents a rally of almost 50% since Wednesday’s close, it’s not totally impossible, so traders will have to be aware that the trade does carry the same risk as being short 100 shares at prices above $450.

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