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A Big Rally and High Volatilities Make Tesla a Candidate for Cash-Covered Puts

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At the end of December, I discussed a strategy for locking in gains for investors who own shares of Tesla (TSLA - Free Report) that have appreciated rapidly over the past 7 months.


But what about those who haven’t owned the shares during that extraordinary rally?


With Tesla now firmly profitable and expanding rapidly into Europe and Asia, it’s likely that a rational investor would want to get involved – expect that the share price has risen so far, so fast that it seems awfully expensive by any conventional quantitative analysis method.


Tesla now has the market cap of Ford (F - Free Report) and General Motors (GM - Free Report) combined – though that’s not exactly an apples-to-apples comparison because those companies are burdened with a much less favorable debt structure that’s hampering equity appreciation.


The markets also expect pretty significant volatility for Tesla, with options trading at about 60% implied annual volatility – or than 4 times the level of the broad markets.


For an investor who wants to own the stock - but at a lower level - those implied volatilities represent an opportunity to get some income potential from the recent rally or possibly to own the shares at a steep discount to the current level.

Since traders are willing to pay more for options on a stock that is moving, or likely to move, they raise the volatility component in their pricing models, raising the price they are willing to pay for options.

In fact, the sophisticated options pricing models used by professional options market makers usually have this change in volatility built in.  When the stock price declines, volatility inputs are automatically raised.

This means that in periods of high volatility, especially on moves to the downside, option sellers receive higher than normal premiums.

If you were thinking of buying the stock anyway, selling out of the money puts can be a less expensive way to go about it.  If the stock continues to decline through the strike price of the put you sold, the option will end up in the money at expiration and you will be obligated to buy the stock at the strike price.

Your net price on the purchase will be the strike price minus the premium you collected on the sale.  Because the put was out of the money when you sold it (it has a strike lower than the current stock price) your basis for the purchase will be lower than the market price for the stock was when you initiated the option trade – effectively a discount.

If the stock doesn’t decline below your strike price, your put will expire out of the money and you will keep the entire premium.

Obviously, there’s risk associated with this strategy because if the stock price continues to decline, you own it and will suffer losses.  It’s the identical risk you assume whenever you buy a stock, except that your net price will be lower than the current share price when you execute the trade.


Right now, the February 400 strike puts in Tesla with 43 days remaining are trading for about $10/each.


If you sell those puts, you can keep $1000/each if the shares stay above the $400 level before expiration. If they decline below $400, you will be assigned on that put and will buy the shares, but your price basis will be $390/share – a more than 20% discount to the current market price.

Risk and Margin

Because of the risk involved, brokerage houses generally require that you have available cash or margin in your account to complete the purchase of the stock in the event that the option ends in the money and you are assigned.  Some houses may also require that you are experienced in trading and/or well capitalized before allowing you to execute a sale in an uncovered option.  You will need to square this away before you trade.

-Dave

Want to apply this winning option strategy and others to your trading? Then be sure to check out our Zacks Options Trader service.

 


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