Tesla Stock’s Run-Up Isn’t Over Yet. How to Play It With Less Risk.

Articles From: Barron's
Website: Barron's

Wall Street can price just about anything, but it always seems to stumble around revolution and innovation. The general public generally struggles with valuation metrics but seems to understand the Next Big Thing with little trouble.

Tesla (ticker: TSLA) is a prime example.

The electric-vehicle company reported good earnings late Wednesday. Analysts had expected a loss. The stock surged even higher in the after-hours market, capping weeks of such strong bullish stock and options trading that it’s hard to fully convey the intensity of the action.

In recent weeks Tesla’s options have traded more actively than every stock in the S&P 500 index other than Apple (AAPL). On average, over the past 20 sessions, about 575,000 contracts traded each day, and Susquehanna’s Chris Jacobson told his clients the majority of that volume was bullish call buying.

So far this year, Tesla’s stock is up some 281%. It is up 501% over the past year. During the past 52 weeks, the stock has ranged between $211 and $1,794.99. Tesla’s options are among the most actively traded in the market, and they have created incredible profits for aggressive investors.

The earnings results provide an opportunity to reset a trade that we recommended a month ago when the stock was sharply lower. At the time, Tesla was trading around $994.32, and we recommended that investors sell Tesla’s January $990 put for $191 and buy the January $1,005 call for $190. The trade paid investors $1 for agreeing to buy Tesla stock at a slightly lower price, while enabling them to participate in rallies above $1,005. At Wednesday’s close, the stock was around $1,592. The put was trading around $98, and the call was around $691, representing a 49% return on the put and 264% return on the call. During the same period, the stock rose 60%.

Any stock that trades above $1,000 is in rarefied territory, especially in the options market. Tesla’s options cost more than most stocks do. Still, options arguably represent one of the best ways to control such an expensive, hot stock, as they make it possible to somewhat define the risk and reward of the position, unlike just buying stock. If you buy stock, and the stock is cut in half, your losses would be far more substantial than if you had used options.

We used our favored risk-reversal strategy last month, but this time we want to readjust to reflect Tesla’s meteoric rise in the past month. The stock could keep rising, but it has advanced so much this year that it seems foolish to not at least consider the possibility that investors decide to realize profits on their stock or options positions, thus triggering a healthy decline in one of the world’s best-performing equities.

To manage that risk without ceding exposure to higher highs, investors can consider a “bull spread” that positions them for continued advances without meaningful exposure to weakness in the stock. It involves buying a call option and selling another with a higher strike price but similar expiration to potentially profit from any advances in the underlying stock.

With Tesla trading around $1,637, investors could buy the January $1,650 call and sell the January $1,750 call for $40. If the stock is at $1,750 at expiration, the spread is worth a maximum profit of $60. (Each options contract represents 100 shares.)

The key risk to the trade is that the stock price falls to a level that is beneath the trading range that is mapped by the spread strategy. Should that happen, the trade fails, and investors would lose the money spent to establish the position.

Critics will say it is unwise to position for further gains in a stock that has advanced so far in such a relatively short period, but they have been saying that for the past 1,500 points. Instead, remember the old saw: Any jackass can kick down a barn, but it takes a carpenter to build one. Elon Musk, Tesla’s CEO, is most certainly a skilled carpenter.

Originally Posted on July 23, 2020 – Tesla Stock’s Run-Up Isn’t Over Yet. How to Play It With Less Risk.

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Disclosure: Options Trading

Options involve risk and are not suitable for all investors. Multiple leg strategies, including spreads, will incur multiple commission charges. For more information read the “Characteristics and Risks of Standardized Options” also known as the options disclosure document (ODD) or visit ibkr.com/occ