Tesla (NASDAQ:), currently the leading name in the electric vehicle (EV) market, announced on July 26. Although the company exceeded expectations, the stock closed nearly 2% on Tuesday afternoon. , for $644.78.
So far in 2021, shares of TSLA are down 10.5%. In the past year, however, the stock has risen more than 115%; it reached a record high in late January. The 52-week range was $273.00 – $900.40 and the market cap was $611.2 billion.
Despite the share price decline so far in 2021, The Street agrees that the stock could have significant upside potential. In fact, in many countries, especially in China, market penetration is still in its infancy. That's why it remains one of the most followed stocks on Wall Street.
Of the 35 analysts surveyed through Investing.com, it has a 12-month average price target of $691.40, representing a return of over 6%.
Therefore, potential investors may consider buying the stocks for their long-term portfolios. However, investing in 100 shares of Tesla stock would cost about $64,478, a significant investment for most people.
Some may prefer to compose a "cover call for a poor person" instead. So today we are introducing a diagonal debit spread on Tesla using LEAPS options. Such a strategy is sometimes used to replicate a covered call position at a significantly lower cost.
Investors new to options may want to re-read our previous articles on LEAPS options (for example, here and here) before reading further.
A diagonal debit spread on Tesla shares
Current price: $644.78
A trader first buys a “longer term” call with a lower strike price. At the same time, the trader sells a “shorter term” call with a higher strike price, creating a long diagonal spread.
The call options for the underlying stocks therefore have different strikes and different expiration dates. The trader goes long one option and short the other to create a diagonal spread.
In this strategy, both the profit potential and the risk are limited. The trader determines the position for a net depreciation (or expense). The net depreciation represents the maximum loss.
Most traders entering such a strategy would be slightly optimistic about the underlying security – here, Tesla. Instead of buying 100 shares of TSLA, the trader would buy a deep-in-the-money LEAPS call option, with that LEAPS call acting as a “ surrogate” for owning the shares.
For the first leg of this strategy, the trader could buy a deep-in-the-money (ITM) LEAPS call, such as the TSLA January 20, 2023, 450-strike call option. This option is currently offered for $285.80. It would cost the trader $28,580 to own this call option that will expire in almost a year and a half instead of $64,478 to buy the 100 shares outright.
The delta of this option is close to 80. Delta shows the amount that the price of an option is expected to move based on a $1 change in the underlying asset.
If Tesla stock rose $1 to $645.78, the current $285.80 option price would be expected to rise about 80 cents based on a delta of 80. However, the actual change could be slightly more or less depend on several other factors beyond the scope of this article.
So the delta of an option increases the deeper one goes into the money. Traders would use deep ITM LEAPS attacks because as the delta approaches 1, a LEAPS option's price movements begin to mirror those of the underlying stock. In simple terms, a delta of 80 would be the same as owning 80 shares of the stock in this example (as opposed to 100 in a regular covered call).
For the second part of this strategy, the trader sells an out-of-the-money (OTM) short-term call, such as the TSLA September 17, 2021, 660-strike call option. The current premium of this option is $38.60. The option seller would receive $3,860, excluding trading commissions.
There are two expiration dates in the strategy, making it quite difficult to give an exact formula for a breakeven point in this trade. Several brokers may offer "profit and loss calculators" for such a trading setup.
To calculate the value of the back-month (i.e., LEAPS call) when the first-month (i.e., the shorter date) call option expires, a pricing model is needed to calculate a "estimate" for a break-even point.
Maximum profit potential
Maximum potential is realized when the share price is equal is at the strike price of the short call on the expiration date. So the trader wants the Tesla stock price to stay as close as possible to the short option strike price (i.e. $660 here) on expiration (on September 17, 2021), without going above it.
Here the maximum return would, in theory, be about $4,624 at a price of $660 at the end, excluding trading commissions and fees. (We arrived at this value using an options profit and loss calculator).
Without the use of such a calculator, we could also arrive at an estimated dollar value. Let's see:
The option seller (i.e., the trader) received $3,860 for the option sold. Meanwhile, underlying Tesla stock rose to $660.00 from $644.78. This is a difference of $15.22 per TSLA share, or $1,522 for 100 shares.
Since the delta of the long LEAPS option is taken 80, the value of the long option will theoretically increase by $1,522 X 0.8 = $1,217.60 (however, in practice it could be more or less than this value. )
The total of $3,860 and $1,217.60 comes to $5,077.60. Although it is not the same as $4,624, we can consider it a good estimated value (by September 17, the long option will lose some of its value due to time decay and add to the difference in result).
It is understandable that if the strike price of our long option had been different (i.e. not $450.00), the delta would have been different as well. Then we have to use that delta value to arrive at the estimated final profit or loss value.
Here, by not investing $64,478 in 100 shares of TSLA initially, the trader's potential returns are exploited.
Ideally, the trader hopes that the short call will expire out-of-the-money. Then the trader can sell one call after another, until the long LEAPS call ends in about a year and a half.
Position management
Active position management in a diagonal debit spread is usually more difficult for novice traders.
If Tesla is above $660 on September 17, the position will return less than its potential maximum return as the short-term option begins to lose money.
Then the trader may feel the need to close the trade early as the price skyrockets and the short call is caught deep in the ITM.
In a regular covered call, the trader will not necessarily mind being assigned the short option, as he/she also owns 100 shares of Tesla. However, in a poor person's covered call, the trader wouldn't necessarily want to get the short call because he/she doesn't actually own those TSLA stocks yet.
On September 17, this LEAPS covered call trade would also theoretically start losing money if the TSLA stock price falls to about $603 or below. Understandably, the price of a stock can drop to $0, decreasing the value of the long call.
In the coming weeks we will continue our discussion with several examples of option strategies.
