The Danger of Buying Long-Dated Calls
Today, I want to highlight the danger of buying long-dated calls. Specifically, on stocks with high implied volatility (IV).
Take Tesla for example. 6 months ago, Tesla was skyrocketing upwards. It was almost a month after the stock split, and Tesla was unstoppable. From mid-March 2020 through September, Tesla was up about 300%.
What we didn’t know is that Tesla had way more upside than anyone could imagine; it would more than double within the next four months.
Knowing this now, it seems like September of 2020 would have been a great time to buy Tesla calls. Let’s say you wanted to buy the April 2021 $700 calls. Tesla was trading in the mid-400’s at the time you would have bought in September, and would climb to $900 in January.
No way this trade could lose, right?
Well, here’s what actually happened to the option:
You would have bought the call for around $200 per share, or $20,000 per contract.
By January, Tesla would be up 100% but you’d be down 50% on your call.
By today (March 2021), you’d be down 91%. Meanwhile, Tesla shares are up about 50% since you entered this trade.
So, what went wrong?
Implied volatility is the answer. The frenzy around Tesla stock in August and September caused a massive spike in IV.
When IV, or premiums on options, are so astronomically high, there is almost no chance of winning by buying long-dated calls.
Think about what the market was saying in September. With Tesla trading at $400, the $700 strike calls traded at $200. This means just to break-even at expiration, Tesla would need to be at $900 ($700 strike + $200 paid for the option).
To make any money by expiration, Tesla would need to be trading above $900.
That $900 break-even price represented a 125% upside in just 6 months.
Is it normal for large caps to move up 125% in 6 months?
Of course not.
Maybe Tesla has been an exception to that rule in the past, but should you be willing to make that bet?
Conclusion
Buying-long dated, out-of-the-money calls on high IV stocks is a bad idea. You are mostly paying for extremely overpriced premium, and your only hope at making a profit is a massive upswing in the stock price that more than offsets your premium paid.
But most likely, the IV is high because that upswing has already happened. Even if it happens again, which it did for Tesla, it needs to be an even larger upswing to offset the market’s high expectations.
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