Trade of the Day: Tesla Puts

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Trade of the Day: Tesla Puts

Tesla puts did fantastic today; on both sides of the trade.

Tesla sold off today and is currently down 3.5%. While the selloff ay have something to do with the crash in Houston over the weekend, the stock probably needed a cool-off anyway.

I’ve talked a lot about reversion to the mean and how it applies to trading. Basically, if a stock does super well for several days, it likely needs to revert to the mean at some point and decline.

While you should never count on timing the market exactly, you can use the reversion to the mean framework to slowly build up a position that will benefit from the reversion. Keep in mind that you could be off by several days, and theta decay on your options (if you’re buying puts) could create a losing trade even if you end up being right about the price.

Tesla puts were a great trade today if you bought them on Friday. They spiked at the open, rocketing over 300% as Tesla declined at the opening bell. Take a look at the chart for the Tesla $700 put expiring on Friday.

How would you have known to buy puts on Friday?

There would have been no sure way to know. But based on the fact that Tesla had done very well the previous three weeks, you could guess that Tesla would have to revert to the mean soon.

Let’s say you got that suspicion last Tuesday. You could have slowly built up a put position over several days, which helps to eliminate the timing risk of buying all your puts at once.

You would have lost slightly for a few days in a row, but the big win today would have offset your losses and turned the trade profitable.

You would have had to sell very quickly, though. As you can see, the $700 put quickly dove about 60% from the peak. That’s why it’s important to have a profit target and stick to it.

The Other Side

At the beginning of this newsletter, I said that Tesla puts were great trades for both sides. What I meant is that someone could have made a ton of money selling the same puts after they spiked.

Using the same principal of reversion to the mean, a 300% spike in a few minutes is usually proceeded by a decline. Of course, you’d need to be careful with your position sizing so that you don’t get wiped out if you’re wrong on the timing.

For example, let’s say you sold the puts after they jumped 200%. You’d still have a ways to go before the top, so you would have needed to size your trade correctly to make sure you could withstand a loss before taking the eventual gain.

It’s also important to have stop loss percentages on the other side. After all, there was no way of knowing that an even steeper decline in Tesla stock wasn’t about to happen. What if you sold the puts and then they shot up 1,000% afterwards?