Let’s suppose for a moment that Elon Musk is serious about a Tesla buyout at $420, how could you trade it?
1) Long Stock
The first and most obvious approach for most traders is to buy shares. As of this writing, the stock is trading at $373.70. That gives you a nice upside of $46.30. That would be about a 12% return at a $420 sale price. That sounds like a decent return, especially if it’s completed shortly.
However, if the market was confident that the buyout was a done deal, the stock would already be trading at $420 or close to it. Just last week, Tesla was below $300 per share. If you listen to the short sellers, Tesla should be even lower than that.
Tesla’s price spiked after the earnings report on numbers that were arguably not that great. But, Elon’s apology to the analysts and other positive news on the call seemed to have a very positive impact on the stock as it soared by nearly $50.
The short sellers are a real issue with Tesla. They have been a bane to Elon and the company, as seen by his frequent tweets and even in the recent letter to employees. If the $420 buyout deal does solidify, the stock could rocket past $420 as short sellers have to buy-to-close their positions – it’s called short squeeze. (See The Anatomy of a Short Squeeze – Tesla (TSLA)
Let’s suppose that you are in the bullish camp and you want to take advantage the move up to the $420 buyout, what trades would you consider? If you like to own stock, this situation appears to be a good candidate for a collar trade.
When I think of the collar trade, I think of it as building a fence around my stock because it limits the range of where the trade can go.
Components of the Collar Trade:
Long Stock – The trader either already owns the stock or purchases the stock.
Short Call – When traders sell a call, they collect a premium but have an obligation to sell the stock at the strike price within a set period of time.
Long Put – The other side of the collar trade is a long put. A long put gives you the right to sell the stock at the strike price within a set period of time.
Traders who own the stock or want to buy the stock can structure a trade that offers good upside potential and protects themselves from a downward movement. The skill in trading the collar comes from choosing the right strikes and expirations and then managing the trade as the stock price, time, and implied volatility change.
What about other options trades? There is nearly an infinite number of option strategies available.
2) Long Call
The most basic option trade is a simple long call. Long calls generally work in a very bullish trend. But what most long call traders fail to consider is the impact of time and implied volatility. While the stock rises, long calls can lose value because of passing time and falling implied volatility.
Right now, the JAN 2019 $410 Long Call is pricing at $22.30 per share or $2,230 per contract plus commissions. If the stock were to go private at $420. Long call traders would have the right to buy 100 shares of the stock for $410 per share. Unfortunately, that would represent a ($1,230) loss for the trader.
Long call traders would probably need to go in-the-money to find a trade that is profitable at the $420 buyout. But the trade is still going to be hurt by time passing and falling Implied Volatility.
It is pretty easy to predict what will happen with time – it is going to move forward and erode the extrinsic value of both calls and puts. Implied Volatility is a straightforward concept. Implied Volatility – as the name would suggest – is the volatility that is implied to happen. Or said another way, it’s the market’s expectation of future zigzaggedness of the stock.
A corollary to implied volatility is “options expensiveness.” Simply put, when implied volatility is low, options are cheap, and when implied volatility is high, options are expensive.
Traders must consider what will happen with implied volatility if the buyout becomes a reality.
Since the 420 tweet, the implied volatility has risen. If the buyout situation becomes a reality, we will see stock move closer to the buyout price and the implied volatility drop. In fact, the implied volatility will fall like a rock once the market is convinced the buyout is real. That means option prices will drop – for both calls and puts.
Implied Volatility doesn’t always have to work in your favor for a trade to work. Long calls will make money, regardless of time and implied volatility, if the stock moves enough. Still, calls are pretty expensive right now.
There are probably better trades.
Skilled options traders will quickly recognize that there are several trades that could be structured to take advantage of all of these things: rising stock price, time moving forward, and implied volatility falling.
3) Collar Trade
As discussed above, just one of those trades is a properly structured collar trade. A simple example that works based on current pricing would be long stock $373.70, short JAN 2019 400 call for $25.05 credit, and long JAN 2019 300 put for $18.55 debit. The pricing on that trade is $367.20 per share or $36,720 for one hundred shares and one contract each of the short call and long put. The maximum loss between now and expiration is $6,720 if the stock goes below $300 and maximum profit is $3,280 if the stock is above $400 at expiration in January 2019.
The collar trade is a dynamic trade and can be adjusted to be profitable for nearly any situation – that’s beyond the scope of this blog post.
4) Bull Put
What if you do not want to own stock? Probably the simplest spread trade for this situation is a bull put.
The bull put involves selling a put that is slightly lower than the current stock price and then buying another put at a lower strike. The short put is an obligation to buy the stock, and the long put offers protection by giving you the right to sell the stock. The breakeven point is the strike of the short put less the credit received. If the stock price stays above the short put, the trade makes money with rising stock price, passing time, and falling implied volatility. The maximum risk is the difference between the put strikes less the credit received. Adjustments could make this trade profitable if the stock moves bearishly.
The 350/300 JAN 2019 bull put is pricing at $13.32 credit or maximum profit of $1,332 on maximum risk $3,668 for one contract. That is more risk than reward, but the trade has a higher probability of making money than losing. If the stock goes to $420, it will hit the maximum profit.
5) Bull Call
A trade similar to the long call is the bull call. The bull call is a long call with a short call at a higher strike. The short call helps lower the cost of the trade, but puts a limit on your profit.
This trade is a gamble because it has a low probability of making a profit. But it does offer a high return on risk.
Right now, the 2019 JAN $410/$420 bull call is pricing at $3.90 per share and has a maximum profit, if the stock expires above $420, of $6.10. So, you are risking $390 to make $610. That’s better than the long call risk profile. It is important to keep the probability in perspective. There is a low probability of this trade working.
6) Call Butterfly
If you are confident of the stock going to $420 and are not averse to low probability trades, an out-of-the-money call butterfly has a tremendous bang for the buck. I recently placed a butterfly at the AUG 2019 expiration, long call $410, two short call $420, and long call $430. The debit is $0.83 per share or $83 per contract. The maximum profit is $917 per contract. If the stock expires at the $420 buyout, this trade would close for that profit.
This trade is essentially a lottery ticket and has a low probability of success. Keep in mind, the stock has to close at precisely $420.00 for the maximum profit.
Options strategies offer many ways to leverage your capital and control your risk and probability. These are just a few ideas.
But for me, I am in that butterfly.
Disclaimer – This should not be considered as a recommendation to buy or sell a security. All information is intended for educational purposes only and in no way should be considered investment advice. Options involve risk and are not suitable for all investors. All rights and obligations of options instruments should be fully understood by individual investors before entering any trade.