Now, It Could Be Safe to Trade Tesla
Tesla is the company that investors have been nervous about. Bulls and bears have different opinions of the future of the company, but they can all agree that there is cause for concern about the company’s future. Many of those concerns were related to the company’s CEO.
In the past few weeks, CEO Elon Musk announced he planned to take the company private at $420 a share, admitted he didn’t have financing for the deal after the stock surged, told the SEC he picked $420 as a joke about marijuana to impress his girlfriend and was recorded smoking marijuana.
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This behavior explains much of the short term volatility in the stock price of Tesla Motors (Nasdaq: TSLA).
The SEC Forces the Company to Step Forward
Traders bought the stock after news that “the SEC settled a lawsuit accusing the company’s founder and CEO Elon Musk of defrauding investors when he tweeted last month that he was considering taking the company private.”
The stock was up more than 15% on the news. Shares of Tesla had plunged last week following the announcement that the SEC had sued Musk.
Musk and Tesla will each pay $20 million under the settlement, the SEC said in a statement Saturday. Under terms of the agreement, Musk also must give up his seat as chairman of the board of directors for at least three years.
The electric car-making company must also appoint two new independent directors to its board, establish a new committee of independent directors and implement additional oversight of Musk’s future communications.
“The resolution is intended to prevent further market disruption and harm to Tesla’s shareholders,” Steven Peikin, co-director of the SEC’s Enforcement Division, said in the statement.
The agreement allows Musk to stay on as CEO of the company that has struggled to meet manufacturing deadlines and slow cash burn.
Tesla’s free cash flow in the second quarter totaled negative $739.5 million, bringing the company to a net loss of $717.5 million, the company reported in August.
Some analysts had said that Musk’s departure would harm Tesla’s brand, fundraising abilities and stakeholders’ confidence if the company lost its key visionary. The original lawsuit had sought to remove him both as chairman and as CEO.
The company’s negative cash flow is a concern and that could weigh on the stock. That could push the stock lower, maintaining the down trend that has been in place for some weeks.
A Trading Strategy to Benefit from Potential Weakness
The prospects of further short-term gains in TSLA seem to be remote. But, significant weakness is also unlikely. Traders should consider using an options strategy known as a bear put spread to benefit from the expected trading range in the stock.
This strategy can be profitable when a trader is looking for a steady or declining stock price during the term of the options. The risks and potential rewards of this strategy are illustrated in the payoff diagram shown below.
Source: The Options Industry Council
A bear put spread consists of buying one put and selling another put at a lower exercise price to offset part of the initial cost of the trade. This trading strategy generally profits if the stock price moves lower. The potential profit is limited, but so is the risk should the stock unexpectedly rally.
The Trade Specifics for TSLA
The bearish outlook for TSLA, at least for the purposes of this trade, is a short-term opinion. To benefit from this outlook, traders can buy put options.
A put option gives the trader the right, but not the obligation, to sell shares at a specified price until the option expire. While buying a put is possible, it can also be expensive. The risk of loss when buying an option is equal to 100% of the amount paid for the option.
To limit the risks, a second put can be sold. This will generate income that can offset the purchase price, potentially allowing a trader to buy a put with a higher exercise price. That increases the probability of success for the trade.
Specifically, the October 12 $290 put can be bought for about $6.00 and the October 12 $285 put can be sold for about $5.00. This trade will cost about $1.00 to enter, or $100 since each contract covers 100 shares, ignoring the cost of commissions which should be small when using a deep discount broker.
The amount paid to enter the trade is the largest possible loss on the trade. This is generally true whenever a trader is creating a debit to enter an options trade. “Creating a debit” means there is a cost to enter the trade. You could create a debit by simply buying puts or calls to open a directional trade.
In this trade, the maximum loss would be equal to the amount spent to open the trade, or $100. This loss would be experienced if TSLA is above $100 when the options expire. In that case, both options would expire worthless.
The maximum gain on the trade is equal to the difference in exercise prices less the amount of the premium paid to open the trade.
For this trade in TSLA, the maximum gain is $4 ($290 – $285 = $5; $5 – $1.00 = $4). This represents $400 per contract since each contract covers 100 shares.
Most brokers will require minimum trading capital equal to the risk on the trade, or $100 to open this trade.
That is a potential gain of about 300% of the amount risked in the trade. This trade delivers the maximum gain if TSLA closes below $285 on October 12 when the options expire.
Put spreads can be used to generate high returns on small amounts of capital several times a year, offering larger percentage gains for small investors willing to accept the risks of this strategy. Those risks, in dollar terms, are relatively small, about $100 for this trade in TSLA.