- December 12, 2020
- Posted by: CoachMike
- Categories: Options Trading, Trading Article
In a market that has made a historic move to the upside over the last 8 months, we are left with many expensive stocks. A perfect example of this is Tesla (Symbol: TSLA). The stock has moved from $400 to $650 since the beginning of November.
As a result, not only is the stock expensive but the options are very pricey as well.
While all traders love to be where the action is at, it can take a large amount of capital to stay active trading stocks like TSLA.
Trading 100 shares of stock would tie up over $60,000 of capital.
Trading an in the money call or put option would tie up over $7000 of capital.
Both of those figures above are not very realistic for most retail traders.
So what else can be done?
I’m going to show you how you can control 100 shares of TSLA stock for less than $350. Here is how it works.
TSLA Vertical Spread
One of our favorite strategies to use at NetPicks is the Vertical Spread. All this means is we are trading 2 options at the same time. We are are going to talk about selling a Vertical Spread to open a trade, which is also known as a Credit Spread.
To sell a Credit Spread, we are going to sell an option that is closer to the stock price and then buy a second option farther away from the stock price in the same expiration cycle. This allows us to put on a risk defined trade for a fraction of the cost.
In the case of TSLA we are looking to lean a little bearish at this point expecting the market to pullback off the overbought levels. We will be selling a Call Credit Spread for this trade.
How The Trade Is Structured
Vertical Spreads can be used in either weekly or monthly options, as long as there is enough volume and open interest. Since TSLA is one of the most active products to trade at the moment, there is plenty of volume and open interest in all expiration cycles. For our example, we are going to use the December 24 weekly options with 12 days left to expiration.
We are going to sell the 650/655 Call Credit Spread to open the trade. All this means is we are selling the 650 call to open the trade and buying the 655 call at the same time. We will be collecting $1.60 or $160 per spread to open the position. This $160 is the max profit potential on the trade.
The max risk on the trade is $340 per spread. This $340 number is calculated by taking the $5 difference between the strike prices and subtracting the $1.60 credit that we collected to open the position. If we are dead wrong on the trade and the stock moves higher the most we can lose on the trade is $340.
How We Make Money On The Trade
The beauty in using a Credit Spread is they give us 5 ways of making money on the trade. With the 650/655 Call Credit Spread we can make money if the stock moves up, down, or sideways as long as the stock stays below $651.60 (the 650 strike of the call option we are selling plus the $1.60 credit we collect to open the trade). The only move that hurts us is if the stock moves above $651.60. With the stock currently trading around $610, we have a $40 cushion for the stock to move against us and we can still make money.
We also make money from time decay adding up. Options lose value every day that they are held. Since we sold the spread to open the trade, the options losing value daily is helping us make money faster.
Finally, we make money as volatility decreases. With the stock stock so active over the last few months, the implied volatility being used to price the options is also high. Over time the implied volatility will contract and as it does it will cause the options to lose value. That helps our credit spread position.
5 Ways Of Making Money With TSLA Call Credit Spread
We like call spreads because we can make money a few different ways:
- We make money if the stock moves higher as long as it stays below $651.60.
- We make money if the stock moves lower as long as it stays below $651.60.
- We make money if the stock moves sideways as long as it stays below $651.60.
- We make money from time decay adding up.
- We make money from volatility decreasing.
How Do We Manage The Trade
The $1.60 or $160 per spread that we collect for opening the trade is the most we can make on the trade. However, we can only make the entire $160 if we hold all the way to expiration. Instead, we would rather close the position when we can keep between 50-75% of the max profit. We will be looking to buy the spread back for $.40 which would allow us to book $1.20 or profit. This would give us 75% of our max profit potential on the trade.
If you want to use a fixed stop on the trade we recommend using a 70% stop. If you use a tighter stop then this on a Credit Spread, it’s easy to get wiggled out of trades early. Since we have 5 ways of making money with a credit spread, these trades can recover very quickly. They are very forgiving trades.
We make money the fastest on this trade if TSLA sells off quickly. However, we don’t need the stock to move lower. If it moves sideways we can be profitable but it will take more patience for the time decay and volatility to work in our favor. The only move we don’t want to see is the stock above $651.60.
You don’t have to shy away from the high flying stocks due to a small account size. By opening up your options toolbox with a Vertical Spread, you are able to drastically cut the cost of the trade. In the case of TSLA, we were able to reduce the cost from over $7000 to buy a long put, down to $340 with the spread. Not only is the cost reduction a great feature, but we will also have a much higher probability of success since we have 5 ways of making money on the trade.
In today’s uncertain market conditions and expensive stock prices, using a mix of options strategies can be crucial to seeing profitable returns. The Vertical Spread is one of our go to strategies that we use on our side to control our risk and produce consistent returns regardless of what the market throws our way.
best explanation of how a credit spread actually works using the actual numbers in the play :) thank you