Two Mid Term Near The Money Call Trade Lessons:TSLA & SYNA

We discussed utilize near the money (NTM) calls to ride the momentum of an ascending stock in the previous article.  Stocks which meet the ‘3M’ criteria might have better chances to outperform the market.

1)Momentum: The underlying stock just breaks up and is in a confirmed uptrend, which is supported by favorable technical indicators and fundamentals.

2) Multiple non-correlated evidences, such as:

  •  The stock is recommended by Investors Business Daily and/or  Barron’s, such as it is on IBD Top 50 or one of the sector leaders.
  •  Phenomenon observed by myself, such as long line when dinning at Chipotle Mexican Grill, more electric cars on streets or in parking lots, more handbags of a brand, a full house of customers in Nordstrom, huge new job listing of your neighboring company (which usually means a M&A event might be imminent)
  •  Outperforming sectors:such as new energy, biotech and internet stocks of last year.

3)Market: We expect market will remain stable or maintain the uptrend. However, if there is a significant correction, most stock will go down with the broad market, no matter how pretty your chart appears to be.

I would like to use my own recent trade experience to help others get a better understanding of Near-The-Money calls.

 TESLA (TSLA)

The Parking Lot of Computer History Museum, Mount View, California

The Parking Lot of Computer History Museum, Mount View, California

My initial position was established in 2009 with an average cost of $22. At that time, I just relocated to Silicon Valley and spend most of my effort working on a startup I co-founded with my friends while keeping an eye on emerging opportunities. Without a mature methodology, I purchased some Tesla shares just because that 100% electric car seemed to be a cool idea for me. Tesla share price had been fluctuated up and down from 2009 to 2013 and Tesla (the car) and TSLA (the stock) had not gained a spot in the Hall of Fame yet. I did not pay much attention until 2013 when I overheard Elon Musk talking about his great venture of Tesla and SpaceX on NPR (National Public Radio) [1]. In the early Spring of 2013, I spotted more and more Tesla cars when I was walking to the park, when I was on traffic duty and when I was in a parking lot [2]. The following  picture was taken on in the parking lot of The Computer History Museum, Mount View, California. My friends in other states confirmed they observed the same phenomenon [3]. Indeed, Tesla is becoming a fashion among the riches [4]. Meanwhile, it has been confirmed Tesla bumped up its productivity by tracking VINs, but still could not match the escalating demand [5].

TSLA started its brilliant run at early 2013. It appreciated 40% and touched $55 in early May. Elon Musk joked about a historical break even quarter. So far Tesla met all requirements of the 3Ms; a confirmed uptrend, a favorable fundamentals, multiple non correlated evidences (endorsements from reputable media, VINs and increasing popularity) and a stable stock market. Since Tesla was going to release the earning report on May 10, 2013, TSLA stock became more volatile. High vega ballooned the call price. A call option which strike is $15 (23%) out of the money and expire 4 months later was asked for $3.30. It might be hard to tell whether the SEP 21 13 $70 Call was still near the money, but I still want sufficient time to ride the uptrend. Fortunately, the rest of the story  unfolded as expected and  TSLA had a tremendous run! Tesla stock gapped up after earning report on May 10, 2013. The robust uptrend easily lasted more than 2 month. I closed all positions with 500% reward. At TSLA SEP 21 13 $70 Call expiration day, share price is 181, a.k.a this call had an intrinsic value of $111, which is 33,600% higher. Someone must have an extremely strong nerve to hold it!

I felt pure lucky for this kind of play. The chance of picking a super bull from thousands of stock are thin. I believe luck is balanced somehow. You won’t be able to lucky for a long run! I mentioned that the first 2Ms,(momentum and multiple irrelevant evidences) are not sufficient to make a trade successful ,if market tanks,the Near The Money Call strategy is hard to be profitable although there might be thousands of evidences.

Sep 21 $70 Call Purchased on May 7th, 2 days before earning report.  TSLA reached $181 at the expiration day

Sep 21 $70 Call Purchased on May 7th, 2 days before earning report. TSLA reached $181 at the expiration day

SYNAPTICS is such a painful lesson I learned. SNAP was in confirmed uptrend since the beginning of the year of 2014. Synapitics is frequently featured on Investors Business Daily’s Top 50 and Sector Leaders. Both Technical Analysis and Fundamental Analysis suggested that the company are in good track to bump up its profit. Some friends of mine left their admirable positions and joined Synaptics, which means SYNA was expanding rapidly. It seemed to be a perfect setup since SYNA easily met all requirements. I purchased $SYNA 19 APR14 65.0 C call which is at the money (ATM) call and have 2 months to run. However, there was a market correction lasted 2 months, SYNA never touched the strike price again in the next 2 months! All of my SYNA calls expired worthlessly! I immediately deleted SYNA from my watch list. However, a few month later, SYNA touched a new high of $92! Actually, it wad in the money right after the cell expired!

SYNA was below $65 until my $65 calls expired. It then advanced to $90

SYNA was below $65 until my $65 calls expired. It then advanced to $90

The take message: It is much difficult to profit from call purchase since we should take strike price, expiration date and the momentum of the underlying stock. Time erosion is still a haunting threat to the call owner.  Sometimes you get tailwind, sometimes the wind turns against you.

Next time, I will introduce Deep In The Money Call to replace margin.

 

A Primer For Option Risk

Understand Option Trade

The higher the risk (or the lower the probability) , the higher the Return on Investment (ROI) and vice versa. We should reject any trade setup which associates with low probability and low ROI. In earning report (ER) season or a volatile market, deep Out-of-Money (OTM) options can be instantly doubled, tripled or zoomed to ten folds or higher.  However, it is extremely difficult for retail investors to profit from this kind of opportunities, or repetitively profit from those opportunities (It is a different story if you have insider information). On the contrary, Market Makers (MM) are more than happy to add extra amount of volatility premium on the option price to hedge their risks.

Some brokerage firms may provide the following information for options and option combos:  Profit Probability, Max Return, Chance of Max Return, Max Loss, Change of Max Loss。It looks like this:

SPXW price

SPX JUL25 ‘14 1975 CALL has unlimited profit potential, or grow N (N>1) folds. Of course, the bigger the N, the lower the probability.   Actually, at the current volatility level (VIX), the probability of double this call option is 15.86%. The distribution of probability looks like this:

SPXW probability

We will discuss the algorithm to calculate probability later . However, never put all your money in a position which Max Loss is 100% and Chance of Max Loss > 0%. There is 46% chance that this SPX JUL25 ‘14 1975 CALL may worth nothing at the expiration. If you put all your money in this position, you may be luck to make big money, but some unexpected events can easily wipe out all the positions.

Option Risk

Someone might experience and be upset when stock goes up sharply, but its call option changes a little or stays the same.  Here is an introduction to the factors which influence the price of an option. It is based upon owning a call option and expect the stock to appreciate.

1. Direction (delta)

If you pick the wrong direction, it is almost impossible to make a profit. Similar to owning a stock, if a stock goes down, it is very likely its underline calls goes down as well.

2.  Gamma

Even if you pick the right direction, but the stock goes up slowly. You can hold stock as long as it remains bullish, but you cannot hold a call like that. Although stock goes north, but it  has not surpassed the strike price and your OTM call becomes a ITM on the expiration day. I am sorry, your calls expires worthlessly.

3. Volatility (vega)

Suppose you bought a stock used to be a very volatile stock, goes up and down 3-5% percent daily, but become much less volatile recently.   That will adversely influence the call option. The higher the vega, the higher the premium on the option. Vega usually collapses after earning report is published when uncertainty is diminishing rapidly. That is the reason that you may bet the ER right but did make much from it.

4. Time (theta)

Time is the only factor which goes one way – down down down! A stock can go up or down, can accelerate or decelerate, can become more volatile or  less volatile. Time can only decay the option value! On the expiration day, theta is extremely negative for the near the money options. Vega and gamma simply run out of time to influence the option price.

5. Split & Dividend

Uneven stock splits,  such as GOOG split into GOOG and GOOGL, might add uncertainties to the option price. It is generally advised to avoid holding the option during this kind of stock splits. Dividend might greatly influence the call price of the value of dividend dwarfs the vega. In that case, you should exercise or sell the call to avoid loss. For example, on December 6, 2012, COSTCO issued a special dividend of $7 (7.2% of the share price). The next day COST closed down $5.36.  Holding a COST call option at market close of December 5th 2012 can result in huge lost because of the sizable dividend.

6.  Liquidity Risk

There is much less option traders than stock traders. Thus, there is usually huge spread between bid and ask price. It can easily make a 10% loss if you buy a option and  decide to sell it shortly.

Summary:

1. Investment is a Marathon, not a sprint.

2. Never all in a trade whose Max Loss is 100% and Chance of Max Loss > 0%.

3. To profit from owning an OTM call option,  you need to be on the right side of delta, gamma, vega and theta. You’d better avoid split and dividend.

Are you ready?