This Might Really Be the Big One
The Big One. It’s something of mythical proportions. It’s the earthquake expected to be strong enough to break California off of the continental United States or the earthquake expected along the New Madrid fault in the Midwest that will wreak havoc.
The phrase applies beyond natural disasters to popular culture references and a rocket that appeared in the movie, Toy Story.
Another rocket is in the news now. It’s a big one but twenty years after Toy Story, it’s inventor assigned it a more imaginative name than the Big One. This is the BFR, the term Elon Musk used to describe his new design and the acronym stands for what you might think it does.
Musk believes his vision will make interplanetary missions possible.
Back on Earth
In addition to making rockets, Musk has another job as the CEO of Tesla, Inc. (Nasdaq: TSLA), the electric car maker.
Tesla is in the news again. The company produced 5,031 Model 3s in the last week of the second quarter.
This was important because Musk had promised investors that the company would make 5,000 Model 3s per week by the end of June.
“The last 12 months were some of the most difficult in Tesla’s history, and we are incredibly proud of the whole Tesla team,” the company said in the filing. “It was not easy, but it was definitely worth it.”
Musk wrote to Tesla staffers that Tesla had achieved its goals. “I think we just became a real car company….” according to CNN.
Despite the good news, the stock sold off.
This marks a potential change in the trading of the stock. TSLA for some time has been known for delivering bad news and in the past, traders shrugged off the news or even pushed the share price higher.
The reaction to this good news leaves some analysts wondering is this about to be the big one for the stock. A favorite of bears, TSLA could finally be poised for a down trend. That would create opportunities for those who are short the stock, but the risks of shorting the stock are high.
In the past, TSLA has frequently made large dollar moves and left shorts with large losses. But, the lack of new highs in the chart above do change the technical picture and the company is still burning a large amount of cash.
Given the uncertainty of the current situation, it seems unlikely the stock will soar higher. If TSLA is now a car company, it could drop sharply and trade based on its earnings rather than hope of game changing technologies.
A Trading Strategy to Benefit From Potential Weakness
The prospects of a short term rebound in TSLA seem to be remote. Traders should consider using an options strategy known as a bear put spread to benefit from the expected downward price move.
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 July 27 $300 put can be bought for about $12.75 and the July 27 $295 put can be sold for about $10.45. This trade will cost about $2.30 to enter, or $230 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 $230. This loss would be experienced if TSLA is above $300 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 $2.70 ($300 – $295 = $5.00; $5.00 – $2.30 = $2.70). This represents $270 per contract since each contract covers 100 shares.
Most brokers will require minimum trading capital equal to the risk on the trade, or $230 to open this trade.
That is a potential gain of about 117% of the amount risked in the trade. This trade delivers the maximum gain if TSLA closes below $295 on July 27 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 $230 for this trade in TSLA.