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Shares of electric automaker Tesla (TSLA) have been on a tear lately, more than doubling since June lows and adding 17% in December alone. A lot of things seem to be falling into place for the company and short-sellers have been covering their positions, pushing the shares to new all-time highs.
Currently, the CBOE Volatility Index is trading right around its multi-year average of 12-13%. Implied volatilities tend to fall as stocks rise.
It’s another story in Tesla options, however. At-the-money calls and puts that expire in February – after the company’s next quarterly report – currently trade at over 45% implied volatility.
Buying options at that kind of volatility is a risky proposition. They have so much time decay that if you don’t experience the move you’re expecting quickly, you’ll lose a lot of money.
So for someone who has been long shares of Tesla and now has solid gains on the books, what’s the next move? Selling means locking in those profits, but also eliminates the risk of watching cash evaporate if the stock pulls back.
Ideally, you could get some protection from a decline, but still participate if the rally continues.
To protect a stock from future declines, the right trade would involve simultaneously buying and selling options to avoid paying some of the huge premiums that the options markets now command.
The answer could be the “Collar.”
The trade involves buying a put below the current value of the market and also selling a call above the market price to offset the cost of that put.
This trade is also sometimes referred to in professional trading as a “risk reversal.”
You give up some of the profit opportunity to the upside, while protecting the portfolio from severe declines.
For every 100 shares owned, you could buy one February 375 put for $21.70 and sell one February 425 call at $18.05. In total you’ll pay $3.65 and the p/l diagram of the entire position will look like this:
I intentionally picked a call strike above the $420/share level that was the focus of Elon Musk’s infamous tweet about taking the company private.
The best part about the trade is that if the stock does rally, but not through $425 before expiration, those calls will expire worthless and you’ll still own the shares.
Owning Tesla has been a home run trade lately, but there’s nothing wrong with locking in a stand-up triple and eliminating the possibility of getting thrown out at the plate…
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Disclosure: Officers, directors and/or employees of Zacks Investment Research may own or have sold short securities and/or hold long and/or short positions in options that are mentioned in this material. An affiliated investment advisory firm may own or have sold short securities and/or hold long and/or short positions in options that are mentioned in this material.
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