After a vicious selloff that saw SolarCity (SCTY) shares cut in half from the late December highs, SolarCity showed signs of a bottom Wednesday.
Click to Enlarge After initially opening lower at $30.01 and trading all the way down to $27.50, SCTY rebounded strongly, closing the day 8.78% higher at $33.82.
To put the power of the reversal in perspective, the move from the low of $27.50 to the close of $33.82 is nearly a 23% rally intraday.
This sort of reversal pattern is usually a strong indication that a stock has made a short-term low.
Additionally, SCTY stock held critical support at the $28 level and completely filled in the gap.
Click to Enlarge Implied volatility also reached heightened levels, a reliable contrarian indication that the selling may have become overdone.
SolarCity stock had been highly correlated to the price of oil, but had seen that correlation breakdown of late.
The recent sharp selloff in SCTY is a classic example of reversion to the mean, with SolarCity now more reasonably priced in relation to oil.
In my previous article on SCTY from Dec. 31, I posited that SolarCity stock had become too extended at the $58 level and suggested selling an out-of-the money call spread to position for profit. The exuberance over the Paris Accord combined with a breakdown in correlation to oil (and a healthy dose of short covering) had driven the SCTY too high, in my opinion.
How to Trade SCTY Stock
Now that SCTY has fallen 43% over the past several weeks, that exuberance has waned and the correlation has realigned, so I am looking for a short-term bottom in SCTY.
With implied volatility near the highs, option selling strategies are favored, meaning positioning with an out-of-the money put spread.
Since SCTY can be a very volatile stock, I want to structure the short put strike well below the $28 support level and near the recent lows at the $25 area to provide a healthy cushion.
Looking out to February, I would sell the SCTY Feb $25 puts and buy the SCTY Feb $22 puts for a 50 cents net credit. These are the regular February options that expire Feb. 19.
The short $25 strike is 26.08% below the $33.82 closing price of SCTY. The maximum gain on the trade is $50 per spread, with the maximum risk of $250 per spread.
Return on risk is 20%. I would look to cover the trade if SCTY makes a new closing low below $25.07, while looking to keep the initial credit if SolarCity stock remains well-behaved.
As of this writing, Tim Biggam did not hold a position in any of the aforementioned securities. Anyone interested in finding out more about option-based strategies or for a free trial of the Delta Desk Research Report can email Tim at tbiggam@deltaderivatives.com.
