Introduction

On August 5th 2022, this tweet appeared on my timeline:

https://twitter.com/jaym217/status/1555571144790507521?s=20&t=ok7yEZ24QHq9XrNO2rI4og

The tweet asserts that the LEAPs are expensive or “priced for perfection”. The next part of the sentence is shaky if you take it literally — “if you can hedge the upside blowout risk”. You “can” sell the straddle for about $50 whether or not you can hedge the upside, but the author is prudently demonstrating where the risk resides. I give a total hall pass to the writing as my own tweets are often thrown together while standing in line at Trader Joe’s.

Allow me to re-word the tweet without worrying about character limits and without feeling rushed.

“Optically, the CVNA LEAP straddle is expensive because it’s trading for the same premium as the strike price. I can’t get burned on the downside so my only concern is the unbounded upside of the call option I’m short, so if I can truncate the potential loss there, this straddle is a good candidate to sell”

The original poster exhibits a solid understanding of options. But…markets are hard. They don’t leave free or near-free money laying around. It turns out, with 5 months of hindsight, this is a good case study in the limits of optically attractive trades.

[In What The Widowmaker Can Teach Us About Trade Prospecting And Fool’s Gold I dissect another optically attractive trade that is really just fool's gold.]

By dissecting what has happened we can learn about how to think of options “dynamically”.

We’ll use a rhetorical approach to this lesson to make it more interactive. Think about your answers before toggling open the answer or discussion.

Building An Understanding Of A Short Option Trade

On August 5, 2022 CVNA closed at $46.98

<aside> ✔️ Assumptions

• For all questions assume zero carry costs. This is a non-dividend paying stock and we assume borrow and lend rates are 0%
• The original tweet referred to LEAPs which are long-dated options. The tweet was referring to the January 19, 2024 expiry. On 8/5/2022, this option had 532 calendar days to expiry (”DTE”)
• We will be focusing on the $50 strike, the same strike the tweet referred to.
• All of our hypothetical trades occur at closing marks.
• Anytime I use an option calculator, I am assuming European-style exercise. This means the option cannot be exercised early. This assumption is convenient for 2 reasons
  • The calculator I use in Excel is a simple Black-Scholes model.
  • The tweet discussed selling the straddle. The European-style straddle cannot be worth more than the American-style so we are being maximally conservative. In other words, the analysis that follows is only stronger with such an assumption since in real life, the tweet referred to a listed equity option which is American-style exercise. </aside>