The Tesla (TSLA) Pullback Makes the Case for Trading Expensive Options of Volatile Stocks

On Wednesday afternoon of this past week, electric car maker and solar power company Tesla (TSLA) reported its fourth quarter earnings numbers.  They were good, or bad, depending on your perspective.  While revenue handily topped expectations of $2.19 billion by rolling in at $2.28 billion, the loss of 69 cents per share was even worse than the expected loss of 43 cents per share.  Throw in the fact that company CEO Elon Musk  conceded it would likely need to raise funds - yet again - and it's no small wonder TSLA shares tanked to the tune of 6.4% the next morning.

And yet, when one takes a step back and looks at a longer-term chart of Tesla shares, you can't help but think a serious setback for the stock was in the cards no matter what Tesla served up Wednesday afternoon.  See, the 60% rally from November's low to this month's high was largely doomed by the fact that a very strong technical ceiling had already been established at the (roughly) $286 level; that's where Tesla stock topped out in September of 2014 and again in July of 2015.  For a well-watched name like Tesla, traders never really forget, and past peaks can often come back into play.

For some savvy options traders who saw it coming though (as most traders arguably should have), TSLA served up a prime option-trading opportunity that's still quite valid.

In simplest terms, now that the ceiling at $286 has been validated, based on the chart's history we can reasonably expect a return trip to the $194 level, or even the $179.50 level, where the stock has made key lows in between the times it was making highs at the $286 mark.

The chart below speaks for itself. The red dashed lines are clearly meaningful floors and ceilings.

The setup makes for a compelling option trading opportunity, though not an easy one to step into for all traders.  

Being a high-priced stock to begin with as well as being a highly volatile stock, option prices on TSLA shares can be particularly frothy.  That's not necessarily a bad thing, though.  While that volatility can work against you rather quickly, it can also work in your favor.  

More important, this is arguably one of those cases where it pays to "go for broke," meaning you can set aside a small amount of capital to buy low-priced (and probably out of the money) put options knowing you could lose it all, but also knowing you can make a small fortune if Tesla shares do their usual thing and make a huge swing lower.

Just as a quick example, you could buy some out-of-the-money April regular  (wk 3) puts with a strike price of $250 for about $11.00...  or $1100 per contract.  It seems like a small fortune for a put that's currently almost $7.00 out of the money; it's technically worth nothing yet.  Again though, a $7.00 move is all in a day's work for this particular stock, particularly when a retreat back to below the $200 mark is plausible...  even likely.

Just for a little perspective on how big of a trade this could be if you're right about the stock peeling back, even a return trip back to the $194 level would put the put option at a price of $56.00....  or $5600 per contract.  That's more than a 400% return on your money.  

Granted, the risk to the trading capital put on the table was arguably almost 100% - Tesla shares and Tesla options are unforgiving for those who guess wrong.  Sometimes though, you have to swing for a grand slam if you want to hit a grand slam.

The moral of the story is, while there's a mental tendency to prefer cheaper options on less volatile stocks, with options trading, sometimes the best play is to play the volatility rather than avoid it.  One does have to have something of a stomach for it, which is why you'd want to go into a trade like this one prepared for a total wipe out; not everyone can do that.  An out-of-the-money option is going to be relatively cheap already though.  In a case like this though, it's a risk that's worth it given how little capital you have to commit to generate a sizeable return.

Don't get the wrong idea - this is an isolated case.  More often than not it's better to abate your risk at the expense of upside rather than aim for a huge reward.  Not every time though. In this case, the higher-odds outcome IS a big move.

If you'd like to capitalize on the inherent volatility of earnings reports, take a look at our BigTrends Earnings Explosion Advisory Service and the BigTrends Earnings Extravaganza Advisory Service. Both newsletters take advantage of such post-earnings swings.