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Trade the Market, Not Your Beliefs About the Market

Trade the Market, Not Your Beliefs About the Market

It is easy to find stories about the stock market based on emotion. That is especially true when a company like Tesla, Inc. (Nasdaq: TSLA) reports earnings. For some reason, Tesla evokes emotions rather than rational analysis from some writers.

One such story appeared on TheStreet.com and told us that “Tesla is absurd” under the headline “Tesla CEO Elon Musk Won’t Solve World Hunger and Save Humanity.” That’s not really a fair criticism since Musk’s goal isn’t to solve world hunger. Elon Musk is simply running a publicly traded company.

An Earnings Report Tells Part of the Story

Tesla posted a smaller-than-expected second quarter loss on Wednesday. In part, the company’s performance was driven by a nearly 100% gain in sales compared to a year ago. Sales are often called “the top line” since they are at the top of the income statement. Earnings are the bottom line.

Below the top line, there was both good news and bad news for analysts to consider.

The number of deliveries of its luxury cars, Model S and Model X cars, grew 53% compared to the same three months of 2016. But, deliveries were down 12% compared to the first quarter of 2017. The company attributed this to a production shortfall of battery packs that has been corrected.

The outlook for deliveries in the second half of 2017 looks better according to the company. Tesla Orders for Model S and Model X cars were up about 15% in July when compared to it’s the average weekly orders in the second quarter.

The bigger story for the company is the recent launch of the Model 3, the car Tesla is calling its mass-market sedan. Initial reviews of the car have been overwhelmingly positive and Tesla reported that it receives an average of more than 1,800 net reservations per day for the car.

The Model 3 is the best selling electric car. As a point of comparison, GM’s Chevy Bolt averaged sales of just over 1,800 cars per month in the first four months of 2017.

To meet demand, Tesla plans on producing 5,000 Model 3 vehicles a week by the end of this year. Next year, plans are to double that level of production. This would be a big jump from the 1,500 vehicles expected to be produced in the third quarter.

Hitting those manufacturing targets would lead to large profits for Tesla. The company reported that it expects to record profit margins of 25% on the Model 3, similar to the margins the company reports on its luxury models. For comparison, analysts noted GM and Ford typically report gross margins of less than 15%.

There Are Some Valid Concerns About the Company

Some analysts noted that the Model 3 is not a typical mass market car. Its $35,000 price tag and limited range of about 310 miles on a fully charged battery limits the market for the car.

At least for now, many buyers are actually paying less than $35,000. Anyone who buys a plug-in car in the US today is eligible for a federal tax credit of up to $7,500. That’s a discount of more than 20% off of the car’s base price.

Skeptics point out that the tax credit is only available on the first 200,000 cars that any manufacturer sells in the US. It’s likely that the credit for Tesla will expire early next year, long before most of the consumers with reservations get their order filled.

Skeptics also point out that Musk has said he will need to raise additional money to support operations. This likely means debt will be issued that will carry interest payments that will hurt the company’s bottom line.

Finally, competition is increasing in the electric car space. Luxury carmakers like Mercedes and BMW are coming to the market and that will be a potential problem for Tesla.

Reading the Chart to Develop an Outlook

Tesla made a large move after announcing earnings. The stock price gained more than 6% to close at $347.09. We can turn to a chart to determine whether the stock is likely to see follow through on its gains, pull back, or fall into a relatively narrow trading range.

The chart below shows the ConnorsRSI indicator at the bottom of the chart. Notice that this indicator has just moved above 70.

Source: TradingView.com

You may not be familiar with this indicator. ConnorsRSI is a unique momentum indicator that incorporates three separate components, a 3 period RSI of the close; a 2 period RSI of the current up/down streak; and a rank of how large today’s move is. Then a simple weighted average is used to combine them.

ConnorsRSI is a unique indicator in that it considers the momentum of the stock price, the duration of the current price trend and the magnitude of the recent price move. For more details on the calculation and how to use it, see this link. Performance of the indicator is summarized below.

Source: AlvarezQuantTrading.com

From that chart, we can see that stocks tend to move higher after the ConnorsRSI moves above 70. They begin to pull back in the five days after the indicator moves above 85. The 5 day pullback is especially strong when the value of the ConnorsRSI indicator tops 95.

This pattern is consistent with the chart of TSLA that is shown above. In the past, when the ConnorsRSI for TSLA has crossed above 70, the stock price and the indicator continued higher.  The indicator forms a clear pattern mimicking the pattern of the stock price. That makes this an important indicator to follow for this stock.

A Specific Trading Strategy

Based on the chart, it appears likely that TSLA will continue moving higher over the short term. Options are, of course, the ideal trading vehicle for short term price moves. Options are also ideal for high priced stocks since they cost significantly less than outright ownership of the stock.

A spread strategy can allow us to reduce the costs of the trade even further.  A bull call spread strategy can be useful for this situation where the outlook is for a steady or rising stock price during the life of the options. The risks and rewards of this strategy are shown in the diagram below.

Source: The Options Industry Council

This strategy consists of buying one call option and selling another call option. The option that is sold will have a higher exercise price than the option which is bought. This reduces the amount of trading capital required to open the trade. Both options will have the same expiration date.

The bull call spread generally profits if the stock price moves higher, just as a regular long call strategy would, up to the point where the short call caps further gains. The benefit of lower costs is therefore offset by the drawback of limited upside.

For TSLA, there are a number of options available expiring on August 11, one week from now. The August 11 $347.50 call is trading at about $7.90. Since each contract covers 100 shares, the total cost would be $790, ignoring commissions which should be small at a discount broker.

To reduce the cost of the trade, the August 11 $353.50 call could be sold. This will generate about $555 in income reducing the cost of the trade to $240, less than one share of the stock at the current price.

The maximum loss is limited to the amount paid to open the trade, or $240. The maximum gain is equal to the difference in the exercise prices less the premium paid or $260, a potential gain of more than 100% in one week.