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Options Lab: SolarCity Corp (SCTY)

Breaking down a hypothetical trade on SCTY

by 8/5/2014 10:51:33 AM
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SolarCity Corp (NASDAQ:SCTY) has had a solid run in 2014. As of last night's close, the shares have tacked on more than 23% to trade at $70.06. Nevertheless, in the last few weeks, the stock has encountered notable resistance in the $75 area. That said, how can someone use options to bet on continued congestion in this overhead area? The answer is fairly simple -- by selling to open calls. Today, therefore, we'll look at a hypothetical trade, focusing on the neutral-to-bearish short call strategy.

Daily Chart of SolarCity (SCTY) since March 2014

Jane Q will be our subject for this morning's case study. After evaluating the data available to her, she decides to gamble that SCTY will not topple the $75 level during the next two weeks. Therefore, she sells 10 August 75 calls at a bid price of $2.56 each, collecting a total premium of $2,560 (premium received * number of contracts * 100 shares per contract). This represents Jane's maximum profit on the transaction, which she'll pocket assuming she's holding onto out-of-the-money contracts at the close on Friday, Aug. 15 -- when the front-month options expire.

On the other side of the equation, Jane has taken on a considerable amount of risk by selling the calls. If SCTY rallies beyond the strike between now and August options expiration, she could be assigned -- in which case, she'll need to deliver the shares for $75 apiece, no matter how much they're worth at the time. To frame it another way, Jane's risk is theoretically unlimited north of breakeven at $77.56 (strike plus premium collected), as it's tied to the price of the underlying stock.

Speaking of which, risk is definitely high on this trade, as SCTY is scheduled to report second-quarter earnings after the market closes this Thursday. While the shares tend to suffer fairly severe post-earnings drops -- which work in Jane's favor -- the equity was up nearly 14% a week after the company's last quarterly event in early May. Were that to happen this time, SCTY would be flirting with the $80 level. In this scenario, she would be staring at a loss of $2.44 per share ($80 current price less $77.56 breakeven price), or $2,440 (per-share loss * 10 contracts * 100 shares per contract) -- plus any transaction fees.

Most likely, unless SCTY gapped significantly higher during pre-market trading, Jane's losses wouldn't reach the aforementioned levels, as she'd likely buy to close the calls before that happened. In that case, her loss would be calculated by taking the ask price of the August 75 call at that time, subtracting the $2.56 premium she received, and adding any brokerage fees paid to close out the position.

Finally, one factor worth noting is the elevated implied volatility (IV) of 95% on the SolarCity Corp (NASDAQ:SCTY) call in question, which is significantly higher than the stock's 20-day historical (realized) volatility of 43.2%. Such a high IV makes now a good time to sell premium on SCTY options. What's more, should the equity move less than expected following its upcoming earnings report, a subsequent volatility crush would make the sold calls much cheaper to buy back.


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