“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.
This week it’s a warning about what not to do.
Don’t speculate on the price of Tesla (TSLA - Free Report) using options.
If you’ve been watching the markets over the past few weeks, you’ve no doubt witnessed the unbelievable rally in Tesla shares. On Wednesday, you also saw how quickly those shares can fall.
Thursday morning it looked like the shares would fall again before an early morning analyst report declaring that Tesla sales in North America in January likely set new records.
During the first three days of the week, Tesla shares were up 20% on Monday, up another 14% on Tuesday (after trading up as much as 23% intraday) and then down 17% on Wednesday.
Those are extraordinary moves in any stock, and even more extraordinary given Tesla’s $140 billion market cap and high-triple digit share price.
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 $55 billion worth of Tesla shares changed hands on Tuesday alone. Second place that day went to Apple (AAPL - Free Report) with about $11 billion traded. Apple is the largest company in the US with a market cap of $1.4 trillion – more than ten times the current size of Tesla.
Most investors who were watching the Tesla action found 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 mid-4-digit share price – 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 $75,000 to control just 100 shares of a $750 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.”
On Tuesday afternoon with about ½ hour left in the trading session, I sent a text to an old friend and former options-trading colleague alerting him that the at-the-money straddle with 17 days left to expiration was trading for $250. The implied vol of those options was about 150%.
(That’s not $250 like a $2.50 option on 100 shares of stock costs a total of $250. That’s two hundred and fifty dollars for each straddle. By a one-lot and you’ll pay $25,000.)
That seemed absurdly high to me.
Almost as soon as I hit “send,” on that message, Tesla shares began a steep decline into the closing bell that saw them shed more than $80 of value in a few minutes.
Suddenly a $250 straddle with 17 days left didn’t seem quite so ridiculous!
Since then, another unexpected thing has been happening – as the shares price has declined, so has the implied vol of options. (In normal circumstances, the opposite is true – vols rise as the stock falls.)
At-the-money options with a February expiration now trade around 110% - still very high, but also much lower than they were just a day and a half ago.
With the shares at $760, that 970 strike straddle that I though was so expensive on Tuesday is trading at $247 dollars. That’s right, it’s barely changed in value, even after a huge move in the stock and the implied vols.
If that doesn’t seem terrifying to you, it should.
If you bought the straddle, you were expecting a big move in the stock – and you got it. Yet you didn’t make a cent yet. If the stock stays here or drifts slowly higher, time decay will take those options lower in a hurry. The only way for you to make money from here is for the stock to turn sharply lower, otherwise you’re going to lose somewhere between $5,000 and $25,000. 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 that gradual rally. If Tesla slides back to where it was just three weeks ago – about $570/share – you’ll lose $15,000. 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 means to responsibly trade a one-lot Tesla straddle for $25,000, you’d have to have liquid capital of between $500k and $1M. 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 over 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 watching 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.