Managing Editor’s Note: Today, we’re handing the reins over to colleague Larry Benedict – a market wizard and legendary hedge fund manager.
He’s been following the recent volatility… He’ll share how he used one hot company’s increasing volatility to make a great profitable trade…
Here’s Larry…
By Larry Benedict, editor, Trading With Larry Benedict
The huge ramp-up in volatility these past couple of weeks has seen plenty of folks call “time out” and head to the sidelines.
But subscribers of my option advisory The Opportunistic Trader embrace volatility rather than fear it. And they recently banked some outsized gains.
Better still, they grabbed those wins quickly…
Like the blended 131.5% gain we made in just eight days from riding the Nasdaq’s big sell-off.
Or the blended 29.5% gain in five days we picked up from a surging gold price. And a 15% gain in a single day from a bounce in oversold government bonds.
Today, though, I want to focus on the trade that saw subscribers snare a blended 54.4% gain from Tesla (TSLA).
The reason for looking at this trade is simple…
It’s nice to cover quick, straight-up winners. But this trade initially went against us.
And it lasted way longer than planned.
Yet we used options to limit risk and let the chart dictate our actions. So we eventually closed out the trade for a tidy profit…
Known Risk
In the chart below, you can see how TSLA traded flat from early May through June.
During that sideways pattern, the 10-day moving average (MA, red line) and the 50-day MA (blue line) tracked closely together.
But as June closed out, TSLA began to move higher. And within a week, it had gained over 15%.
Almost half of that move came on July 1 – the day we entered the trade.
Tesla (TSLA)
Source: eSignal
But the move higher looked overdone.
The Relative Strength Index (RSI) was tracking in the overbought range. That’s above the 70% level.
And TSLA planned to announce expected deliveries the following week. So we set ourselves to capture any surprise to the downside.
We did that by buying a put option. A put option increases in value if the underlying stock falls.
But from the moment we entered the trade, things didn’t go our way at all.
TSLA continued to rally up to its peak on July 11.
When you see a chart like this, it’s worth remembering why we trade options.
By buying options, we know exactly how much we stand to lose if the trade doesn’t go our way.
In this trade, we paid $4.68 per contract, which equates to $468. (An option contract is for 100 shares.) So $468 per contract is the most traders had at risk.
Compare that to short-selling shares instead. In this case, that would’ve led to severe losses…
Yet TSLA’s surge put the RSI even further in overbought territory.
And a triangular pattern formed (green lines). So, we decided to give this trade a chance to reverse.
When a triangular pattern develops along with declining momentum, a stock can often break sharply lower.
And that’s what we saw… Take another look:
Tesla (TSLA)
Source: eSignal
TSLA gapped lower, consolidated for a period, then broke lower again.
This coincided with a firm downtrend in buying momentum (RSI).
TSLA was near our trade entry point once more. But there was still uncertainty whether this trade would turn around for us.
The trade rebounded on August 2. So we decided to close out half our position for a 26.3% loss.
That reduced our exposure to this trade. But we kept half our position open to take part in any further down move by TSLA.
And that proved to be the right call…
On August 5, TSLA opened much lower as markets all over the world tanked. Japan led the plunge, with its biggest one-day drop since the 1987 crash.
Our put option position burst into large profit. And we closed out the remainder of our trade for a 135% gain.
With the 26.3% loss on the first part of the trade, that equates to a blended 54.4% gain.
A big part of our trade’s turnaround and subsequent profit was due to TSLA’s big fall.
But it wasn’t the only thing. A spike in volatility also played into our hands…
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Catch Rising Volatility
The huge stock market fall earlier this month saw the CBOE Volatility Index (VIX) hit its third-highest level ever…
And that caused option premiums to soar.
We’re not always going to get this type of tailwind. But it reinforces a basic tenet when it comes to buying options…
We should always aim to buy options when volatility is low but increasing. Do that, and it greatly puts the odds in your favor.
To be clear, options can magnify returns and losses compared to just trading shares instead.
And because options have a finite life, time decay is constantly eroding the option’s value. If the move you expected doesn’t come and you hold your option to expiration, your position can expire worthless.
But that’s the known risk you take to generate outsized gains – just as we did with our TSLA trade.
Happy Trading,
Larry Benedict
Editor, Trading With Larry Benedict