Newbie Options Trading

[Jonathan Hewitt]

While we are talking about LEAPS...I think it's good to get some newbie questions out there!

1. I am seeing LEAPS as an awesome way to get a lot of leverage in TSLA while minimizing my actual overall investment as I believe the share price will keep going up in the long run. Based on what I have read, most people are seeming to recommend waiting to buy LEAPS until after the earnings report so the IV value will go down, thus lowering the acquisition price for LEAPS. I guess this strategy assumes the share price will stay the same or go down, because if share price goes up then the intrinsic value will probably go up more than the IV value going down? Who knows what will actually happen after the earnings report, but I wanted to make sure I understood the mechanics of things so I can make a well educated decision.

2. My next question regards how to choose a strike price to buy LEAPS at. From what I've read in these forums, the most popular way would be to decide what I think the stock price will be at option expiration (let's say $70 for the JAN 15 options for an example), multiply that value by .8, and there's the strike price I should buy at (in this case $56). If this is true, this would agree with my excel spreadsheet I made that let's me put INPUT my estimated final share price, the strike price, and the asking price, and it OUTPUTS a % gain assuming the option is held until expiration (assuming you hold onto it until expiration, an assumption I make as it's ease to model in excel). For example, if I plug in $70 the best percent gain is for the $55 strike price with a gain of 219% (for future reference I used the last market closing asking price of $4.7 to be conservative and common share price was $51.20).

I would say the tricky part for this method is deciding the final price. In this case buying in at $55 gives you no intrinsic value. You are paying for its time value. If the stock doesn't make it to even $60 in this case you end up with 0 profit (but at least no losses). On the other hand, a $60 share price come January will still net a 64% return for both the $40 call and the $45 call. That's not too shabby, especially considering the $70 share price in January 14 scenario would still net you 146% and 175% for the $40 and $45 calls, respectively. In other words, depending on how sure you are of your target price you may want to ease off it a little bit for more buffer? If the stock tanks that opens up another whole analysis but you'd have to have calls very deep in the money to not have a complete loss in that case.

I'll stop rambling here. Any type of feedback is appreciated since I am brand new to this stuff. If I'm completely off or wrong I would like to hear it!

 

[kenliles]

While we are talking about LEAPS...I think it's good to get some newbie questions out there!

1. I am seeing LEAPS as an awesome way to get a lot of leverage in TSLA while minimizing my actual overall investment as I believe the share price will keep going up in the long run. Based on what I have read, most people are seeming to recommend waiting to buy LEAPS until after the earnings report so the IV value will go down, thus lowering the acquisition price for LEAPS. I guess this strategy assumes the share price will stay the same or go down, because if share price goes up then the intrinsic value will probably go up more than the IV value going down? Who knows what will actually happen after the earnings report, but I wanted to make sure I understood the mechanics of things so I can make a well educated decision.

Yes that's a reasonable set of conclusions. Everything else being equal, buy them after earnings report with a likely lower IV. At the same time we know everything will not be equal, new price, new information will likely dwarf any IV difference as you pointed out. Especially true with LEAPS, who's IV movements are less than short dated options. In fact, I would decide whether to buy them based on other criteria like where you think they will go after the report. Or in fence sitting cases, I've done both. Namely half in front and half after. My advice is to hedge your play commensurate with your uncertainty of the event(s), and use something like IV as a tie breaker but not fully weighted decision parameter

2. My next question regards how to choose a strike price to buy LEAPS at. From what I've read in these forums, the most popular way would be to decide what I think the stock price will be at option expiration (let's say $70 for the JAN 15 options for an example), multiply that value by .8, and there's the strike price I should buy at (in this case $56). If this is true, this would agree with my excel spreadsheet I made that let's me put INPUT my estimated final share price, the strike price, and the asking price, and it OUTPUTS a % gain assuming the option is held until expiration (assuming you hold onto it until expiration, an assumption I make as it's ease to model in excel). For example, if I plug in $70 the best percent gain is for the $55 strike price with a gain of 219% (for future reference I used the last market closing asking price of $4.7 to be conservative and common share price was $51.20).

I would say the tricky part for this method is deciding the final price. In this case buying in at $55 gives you no intrinsic value. You are paying for its time value. If the stock doesn't make it to even $60 in this case you end up with 0 profit (but at least no losses). On the other hand, a $60 share price come January will still net a 64% return for both the $40 call and the $45 call. That's not too shabby, especially considering the $70 share price in January 14 scenario would still net you 146% and 175% for the $40 and $45 calls, respectively. In other words, depending on how sure you are of your target price you may want to ease off it a little bit for more buffer? If the stock tanks that opens up another whole analysis but you'd have to have calls very deep in the money to not have a complete loss in that case.

I'll stop rambling here. Any type of feedback is appreciated since I am brand new to this stuff. If I'm completely off or wrong I would like to hear it!

Rambling often produces good thoughts, I would in courage it!
Yep, I think you've got those basics right from my seat here. I'll offer the following 2 other points to consider. With a volatile stock like Tesla (matching its market and belief system volatility), resign yourself to the fact that your prediction of where the stock will be at LEAP expiration has a 6000% chance of being 100% wrong. In other words the granularity of the exercising that prediction into a calculation of 80% of it equals my selected strike indicates too much emphasis on a systematic approach to that decision.

It's true you have to decide based on something and nothing wrong with that framework. Of course it depends on how many options your doing, but one method that works well for me in the past is to select a range, similar to dispersing stock risk. Consider an call deeper in the money better protected and a call out of the money more risky, but with higher return potential. In this way by one call at each of a spread of strikes in your range rather than leveraging all your play against 80% of a what will inevitably prove to be a wild-ass-guess.

My second point to consider is do not expect (again given the nature of this investment) to carry the LEAPS to expiration. Even as a stock replacement tool, I would wager the odds that you'll sell to close before expiration much higher than either lapsing expiration or exercising the call. As TSLA moves over this time, re-evaluation will likely dictate a roll up in strike, a lighter position etc. Just as with a stock holding, he advantage of a LEAP is can make these decisions based on events and new information rather against a backdrop of imminent option expiration (nothing against those plays mind you, they are just different types)

Ramble On!
edit:
(yes, that's a subliminal reference to GrandFunkRailroad)

 

[Jonathan Hewitt]

Ramble On!

Thanks for your advice and encouragement! I like the idea of giving myself options (haha) by buying multiple calls. I will have to play with excel some more and create some more scenarios and mixes of calls to determine what's optimal for me as far as risk and where my WAG sees the stock going.

Yes, I don't actually intend to carry them until expiration or anywhere near there. I'll be surprised if I still have them come January? Being a newbie I'd rather not put more than a thousand dollars at this time into short term options as one bad news event will make them worthless and I don't know if I'm ready for that kind of risk yet. I understand the company could go bankrupt at any time but I view that possibility as a lot lower than another Broder type event happening right before my options expire. Having a lot of time before expiration gives time for the share price to unBroder itself! I was thinking of rolling JAN 14 LEAPS into JAN 15 LEAPS as the year progresses but will need advice in that area at some point on what to consider when doing that .

I will still keep a majority of my TSLA investment in stock but figured a couple thousand in LEAPS would be worth the risk, especially if I sell off a little stock to pay for them.

 

[Robert.Boston]

To reinforce a point @kenlilies makes: one doesn't normally carry a LEAPS position through to expiration. One of the critical elements of this investment play is avoiding theta decay, i.e. the collapse of the intrinsic value of an option as it approaches the expiration date. The usual LEAPS strategy is to close out the original position when it's still 6 months or more out and roll it into a new 12- to 18-month option.

 

[kenliles]

That's an excellent point from Robert to reiterate and keep in mind. The time value of the option degrades at an accelerated pace the closer you get to expiration. It's closer to linear 6-18 months out, but acceleration begins to slowly increase (not just the rate, the rate of the rate). And inside 1 month it's extreme (relative to the LEAP strategy). I've carried them as close as, 2-3 months out, but as Robert said, you should really target a 6 months out roll; that give you some leeway.

In fact, I've already rolled most of my J14s to J15s, a little earlier than usual due to the unexpected jump to $52. Normally would have simply rolled up in strike, but took the opportunity to go out in expiration at the same time. J14 still a good play, gives you a 2-3 months to roll em out, I just went a little early this year

I think he J16s come available in Dec. Can't remember off the top which cycle group TSLA is in.

 

[Jonathan Hewitt]

If you don't mind me asking, what criteria do you consider when deciding to roll up in strike or going out in expiration for LEAPS? I know if your strike is much less than the current price people usually roll up but that's as far as I understand things.

 

[PureAmps]

1. I am seeing LEAPS as an awesome way to get a lot of leverage in TSLA while minimizing my actual overall investment as I believe the share price will keep going up in the long run. Based on what I have read, most people are seeming to recommend waiting to buy LEAPS until after the earnings report so the IV value will go down, thus lowering the acquisition price for LEAPS. I guess this strategy assumes the share price will stay the same or go down, because if share price goes up then the intrinsic value will probably go up more than the IV value going down? Who knows what will actually happen after the earnings report, but I wanted to make sure I understood the mechanics of things so I can make a well educated decision.

As with anything in life, timing is everything. So yes, I would wait for a good entry point. Generally that is after a pullback in the stock, which will happen, as it has a very good run recently. The earnings call will probably be a catalyst for a pullback, as they have already pre-announced the major news (as far as we know, at least).

2. My next question regards how to choose a strike price to buy LEAPS at. From what I've read in these forums, the most popular way would be to decide what I think the stock price will be at option expiration (let's say $70 for the JAN 15 options for an example), multiply that value by .8, and there's the strike price I should buy at (in this case $56).

From my experience with LEAPs, it is always best to buy at around 80% of the *current* stock price, not the price you predict. This gives you extra cushion if the stock moves against you (and it probably will). Using this strategy I've had returns of >300% on AAPL when I bought at the "right" time. I've also bought at the "wrong" time (early 2008) had the stock lose a lot of value, slowly recover and still eek out a 15% profit as expiration approached. I have also lost money on LEAPs, almost entirely in 2008/2009, for LEAPs I had bought in prior years, where the stock just couldn't recover fast enough. As others have mentioned theta decay accelerates near the end of expiration, so at some point you have to know when to throw in the towel and take the loss.

 

[cwerdna]

That's an excellent point from Robert to reiterate and keep in mind. The time value of the option degrades at an accelerated pace the closer you get to expiration. It's closer to linear 6-18 months out, but acceleration begins to slowly increase (not just the rate, the rate of the rate). And inside 1 month it's extreme (relative to the LEAP strategy).

Heh, re: inside 1 month. In my strat on other stocks where I sell naked OTM puts to collect premium, I often only sell within a 1 month's expiration and no more than ~50 days out. I don't go too far out and never want mine to expire after an earnings event. But then again, my play is where time decay is on my side.

I sometimes do the above on weeklies of high priced stocks (e.g. AAPL when it was above its 200 D SMA, GOOG, etc.)

From my experience with LEAPs, it is always best to buy at around 80% of the *current* stock price, not the price you predict. This gives you extra cushion if the stock moves against you (and it probably will).

So, in other words, you want to buy ITM LEAPS calls. If one were to buy now, you'd be buying the 40 strike calls, right?

 

[kenliles]

Heh, re: inside 1 month. In my strat on other stocks where I sell naked OTM puts to collect premium, I often only sell within a 1 month's expiration and no more than ~50 days out. I don't go too far out and never want mine to expire after an earnings event. But then again, my play is where time decay is on my side.

I sometimes do the above on weeklies of high priced stocks (e.g. AAPL when it was above its 200 D SMA, GOOG, etc.)

So, in other words, you want to buy ITM LEAPS calls. If one were to buy now, you'd be buying the 40 strike calls, right?

Those are great examples actually. Put sell you gain on the time decay, nice. Yes the time frame given is referenced more to a LEAPS scenario where you have a lot of $/contract on the line in lieu of carrying the stock. In a shorter date,option I agree, carry it closer commensurate with the risk of that option. I have some OTM May calls in that category

Kind of agree with PureAmps. Odds are decent we'll get a pullback from current levels. I would (and have buy J14 around $40 strike today, $40-$50 for J15, although some higher might be worth the risk. My previous J14 and J15s were at $30. Made good profit and rolled them up now to $40-$45, but would have done better at a higher strike carting more contracts. It Ain't Easy... (Another song I like)

 

[ShortSlaver]

As with anything in life, timing is everything. So yes, I would wait for a good entry point. Generally that is after a pullback in the stock, which will happen, as it has a very good run recently. The earnings call will probably be a catalyst for a pullback, as they have already pre-announced the major news (as far as we know, at least).

I disagree with that - at least the "probably" term. I believe the earnings call could contain more good news than stated and what's baked into the price right now. The earnings announcement hinted at some thing but pretty much said at least 4800. They could have sold a few hundred more, right? In addition, there might be substantial sales going forward pushing the total year estimate higher than 20k, which the guidance could state. Looking at estimates recorded from reported VIN's and such in this forum, you get the feeling there might be even better news than expected.

I agree the earnings call is a catalyst that could push the value down. However, I believe there's potential that it could dramatically push the value up. Everything they've announced so far and going forward (likely building many charging stations is the nest announcement I imagine) suggests they have more capital than expected, to me...

 

[PureAmps]

So, in other words, you want to buy ITM LEAPS calls. If one were to buy now, you'd be buying the 40 strike calls, right?

Yes, if I were buying right now (and I wouldn't), I would most likely buy the 40 strike. I say "most likely" because I have my own toolset I've developed over time for modeling LEAPs, so I usually run a quick sanity check based on the current pricing info. But 9 times out of 10, the recommended strike tends to in the 75-80% range of the current stock price. 80% is a good rule of thumb.

 

[kenliles]

Yes, if I were buying right now (and I wouldn't), I would most likely buy the 40 strike. I say "most likely" because I have my own toolset I've developed over time for modeling LEAPs, so I usually run a quick sanity check based on the current pricing info. But 9 times out of 10, the recommended strike tends to in the 75-80% range of the current stock price. 80% is a good rule of thumb.

Good confirmation. I have no such tool, just a few years of brute force. My set of experiences form a bell curve for LEAPS here on the lower side of a $40-$45 range. I'm currently light (due to run up profit taking), but will be adding on the next pull back spread $40-$50. I'd play J14s at $40 and J15 spread $40 to $50; might even throw in a J15 $60 or 2. I believe TSLA will move faster than the normal long play on a percentage basis

 

[DonPedro]

I agree with ShortSlaver. As luvb2b has so nicely demonstrated in another thread, the Q1 results may be far better than just a marginal "GAAP/non-GAAP profit". My personal best-case scenario is a positive earnings surprise, >5k cars delivered, guidance on profitability in all quarters of 2013 and an increased 2013 delivery target. Then a few weeks of shorts being squeezed.

On the other hand, I also agree that a pullback is not a completely unrealistic scenario, if the earnings news are just "as expected".

 

[Robert.Boston]

A note to newbies: the fact that we have several seriously well-informed traders with proprietary modeling tools--just here in this little subset of the investing world--should make you think twice about whether you want to dip your toes into these waters. Moreso than equities trading, options trading requires paying attention and being willing and able to move quickly. While there are richer potential rewards, there is greater potential risk, too.

 

[hershey101]

Can someone explain how splits affect options prices, especially on LEAPS?

 

[smorgasbord]

A note to newbies: ...While there are richer potential rewards, there is greater potential risk, too.

While Robert's advice is prudent, I just want to say that it was warnings like this that kept me out of options for too long. As has been pointed out in the Advanced thread, options can be used to reduce risk.

If you get into options slowly and stick to simple strategies like selling covered Calls (don't do on TSLA, btw), selling Puts instead of buying stock, buying Puts to lock in profits, and entering Synthetic Longs instead of buying stock, then you'll be OK. Avoid the strangles, iron condors, etc. for a while, and treat every share you leverage via options as if you have real money buying it (ie, don't over leverage) and you'll be fine.

 

[kenliles]

Can someone explain how splits affect options prices, especially on LEAPS?

They are adjusted like the stock automatically- no net effect (other than the demand reflected based on the split of course);
ex. - 2:1 stock split
If you owned 1 Call at $40 strike before, you'll own 2 Calls at $20 strike after
ditto for all options

 

[brianman]

They are adjusted like the stock automatically- no net effect (other than the demand reflected based on the split of course);
ex. - 2:1 stock split
If you owned 1 Call at $40 strike before, you'll own 2 Calls at $20 strike after
ditto for all options

There's a little net effect. When a stock splits, from say $22.50 to $11.25 it can have an impact on the options market in the sense that typical options don't work at $0.25 multiples but rather $0.50 multiples. This can cause a little additional wiggle as investors adjust.

 

[Jonathan Hewitt]

I bought 3 contracts of the May 18th '13 call a about a week ago for $2.6 a contract. It is now worth 3.2 a contract. While the total out of pocket cost really wasn't high, I really don't know if I feel comfortable losing the $800 if TSLA tanks after the conference call when I know I can sell now and have a profit. I'd rather have the known (small) profit now than the possibility of amazing gains after the earnings report release.

My original plan was to sell 2 and hold 1 through the call, using the profits of the first two to dampen the blow if I lose all value on the third one. Just this morning I had another idea. What if I sold a covered call at a strike price of $65 in conjunction with my other plan? If the stock goes down I lose the $260 on the call, but between the $100 from selling the covered call and the $120 from selling my 2 calls I bought that would almost cover the loss. If it goes up, I do better, until it reaches $65 at which point I limit my gains as any other upside that I would gain on the $55 call would be canceled out by the covered call I sold but I still keep the premium for selling the covered call, so that sweetens it.

Does my new idea sound totally stupid? I may even wait and see if the price goes up anymore by Wednesday, which could make the numbers work more in my favor.

P.S.
I tried searching the internet on infor regarding this and the closest I could find was something called a "front spread with calls" but that involved selling twice as many covered calls as you buy. I'm not interested in that.

 

[deonb]

What if I sold a covered call at a strike price of $65 in conjunction with my other plan? If the stock goes down I lose the $260 on the call, but between the $100 from selling the covered call and the $120 from selling my 2 calls I bought that would almost cover the loss. If it goes up, I do better, until it reaches $65 at which point I limit my gains as any other upside that I would gain on the $55 call would be canceled out by the covered call I sold but I still keep the premium for selling the covered call, so that sweetens it.

Does my new idea sound totally stupid? I may even wait and see if the price goes up anymore by Wednesday, which could make the numbers work more in my favor.

P.S.
I tried searching the internet on infor regarding this and the closest I could find was something called a "front spread with calls" but that involved selling twice as many covered calls as you buy. I'm not interested in that.

That's called a bull call spread.

However, you generally can't do one in an ordinary options account - you need to have naked call writing capabilities for that. Do you have that available?

Alternatively do you have the shares in your account for the coverage? I wouldn't recommend a true covered call against TSLA though, the shorts are really depressing the call prices, so you get very little premium against having all that downside risk (won't be able to put in a stop loss order against your shares).