Tesla witnessed a remarkable surge Monday. A Morgan Stanley upgrade sent Tesla stock 10% higher. It joined Leaderboard early in the day and already had a nice profit due to the sharp rise.
Today's strategy will use puts to create a broken-wing butterfly that can provide a little income on the upside or a healthy profit zone on the downside.
TSLA stock has reclaimed its position above the 50-day moving average, and it appears poised to stay above this key level.
According to IBD Stock Checkup, Tesla stock is ranked No. 2 in its group and has a Composite Rating of 96, an EPS Rating of 93 and a Relative Strength Rating of 92.
Setting Up A Broken-Wing Butterfly On Tesla Stock
With a butterfly option strategy you sell two options at the same strike and then buy an option on strikes at either side for protection. These strikes are equal distance from the short strike.
You also have two break-evens with the regular butterfly. One where the stock trades higher than your expected range and one where it trades lower.
But for this Tesla stock option trade, we'll use a broken-wing butterfly. The difference is that you leave a larger gap on a particular side. It's often also known as a skip-strike butterfly because you skip the strike on one side and go to the next one.
This results in less risk on one side and more risk on the opposite side.
Let's take a look at how a broken wing butterfly trade might be set up on TSLA stock. We'll use puts for this trade because the strikes will all be below the stock price. This helps to reduce assignment risk.
- Buy to open 1 TSLA stock Oct. 20-expiration put with a 240 strike price @ 6.50
- Sell to open 2 TSLA Oct. 20 puts with a 255 strike price @ 11.20 each
- Buy to open 1 TSLA Oct. 20 put with a 265 strike price @ 15.40 each
Notice that the upper strike put is 10 points away from the middle put. The lower put "skipped" the 245 strike and went to the 240 strike that is 15 points away.
Managing The Trade
This broken wing butterfly trade will result in a net credit of $50, which means there is no risk if the stock remains above 265.
The downside risk is if Tesla stock falls below 245. The maximum loss is calculated as the difference in the widths (15 — 10 = 5) multiplied by 100 minus the credit received. That works out to a maximum loss of $450. A highly likely scenario is that Tesla stock stays here or goes higher and you get an 11% return on risk ($50 profit/$450 maximum loss).
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But if Tesla stock drifts lower to the short strikes at 255, your profit actually goes higher. If Tesla stock closes right at 255 at expiration, both the short strikes would expire worthless as well as the long put at 240. You would have 10 points of premium on the 265 put plus the credit received for a maximum potential profit of $1,050.
The ideal scenario for the trade is that TSLA stock stays flat initially and then slowly drifts lower to close around 255 at expiration. There is a large profit zone between 245 and 265.
As the trade starts with delta of 2, it has a slight bullish bias to start, but that will flip to negative delta closer to expiry if the stock is still above 265.
In terms of risk management, I would set a stop loss of 20% of the capital at risk, or if TSLA broke below 245.
Trade Updates
The put ratio spread trade on Advanced Micro Devices has achieved a nice profit. With expiration approaching at the end of this week it can be closed early.
An unbalanced iron condor on Uber Technologies achieved more than 50% of the max profit and can also be closed ahead of its Oct. 20 expiration.
Please remember that options are risky, and investors can lose 100% of their investment.
This article is for education purposes only and not a trade recommendation. Remember to always do your own due diligence and consult your financial advisor before making any investment decisions
Gavin McMaster has a Masters in Applied Finance and Investment. He specializes in income trading using options, is very conservative in his style and believes patience in waiting for the best setups is the key to successful trading. Follow him on Twitter at @OptiontradinIQ
