Tesla Inc. (TSLA) is one of the most popular stocks amongst investors. Led by CEO Elon Musk the electric vehicle manufacturer has disrupted the transportation industry, bringing hype to a faithful consumer and investor base.
The chart shows one-year of stock price performance, which at peak increased close to 10 times.
TSLA — 12 month percentage price change. Data source: Yahoo Finance
TSLA option prices are high
Tesla stock prices are very volatile compared to those of other stocks. Volatility, the measure of stock price movements, comes in two closely related types:
- Historical volatility, observed from recent price changes
- Implied volatility, the future movement implied in option prices and their parameters
Tesla volatility is high by both measures. Option premiums on the stock also command significant prices. A three month at the money option costs 18.5% of the stock price and a one-year at the money option 31%.
In comparison, a three-month SPDR S&P 500 ETF Trust (SPY) at the money option costs 5% of the ETF price, and a one-year SPY at the money option costs 9%.
Index volatilities are lower, but the comparison offers a contrast to Tesla’s volatility level.
High-strike TSLA options are more expensive
For growth and technology stocks, prices are expected to move faster when going up. The tendency is to have a “melt up” from high demand as prices rise.
High strike options (on the call side) also are in demand, as the options provide leveraged exposure to upward stock price movements.
These factors make high strike options premiums expensive.
For example, a 20% out of the money call (struck above the current stock price) with three months to expiration costs 13% of the stock price.
A same expiration put struck 20% below the current stock price costs 9%. A similar premium relationship exists for other expirations.
Two option strategies
The first is a covered call strategy. This strategy consists of buying the stock and selling a call option for the same number of stocks purchased.
Given the high volatility of the stock, a high premium is collected. A one year at the money option struck at the current stock price has a 31% premium.
The stock cost basis is reduced by the premium. For the example above, if the stock at expiration is at or above its current price the return is 45% of the cash invested. The maximum combined payout at expiration is the strike.
Covered calls can be used for profit-taking on current holdings. Since the stock has appreciated heavily, selling a call option may lock in a gain, preserving upside with an attractive risk reward.
In aggregate covered calls are less volatile than underlying stocks, as stock price movements are partially counterbalanced by premium value changes. This strategy is attractive if you like the stock but think it is overvalued.
If high-strike, out of the money calls are used, upside is preserved while collecting premium. This takes advantage of the relative high cost of such options.
Drawbacks are a capped upside and unprotected downside below the strike.
The second strategy is a bull call spread. This consists of simultaneously buying a call option and selling a call option with a higher strike, both for the same expiration date. The maximum payout is the range between the two strikes.
For example, a three-month at the money call (same strike as the current stock price) costs 18.5% of the stock price, and a 20% out of the money three-month call costs 13%.
A three-month bull call spread, from the current stock price to 20% above costs 5.5% or 27.5% of the spread range. The maximum payout is 20%, occurring when the stock expires above the high strike.
A similar one-year expiration spread costs 5% of the current stock price, for an at the money to 20% out of the money spread with 20% maximum payout.
For a stock so volatile, such option spreads are close to coin tosses. In this case the net cost of the strategy is reduced by the high strike call being sold.
The main drawback of bull call spreads is the potential loss of the net premium paid. The position is highly leveraged by design, so the net capital allocated should be carefully weighted.