Tesla Shares drop as sales lower than expected

Tesla shares closed 2019 at a price of $418.33 and reached a peak of over $900 in February before the ‘Covid’ effect saw them retreat to around $360. If hindsight were a trading tool we would all be rich as the increase in Elon Musk’s car maker has been phenomenal from that point on, multiplying 5x, peaking at nearly $1800 in July 2020 before settling back to their current level around $1495.

The market cap now stands around $275bln, but as of today Tesla has not been admitted in to the S&P500 index which is a collection of America’s biggest 500 companies. This may seem strange as the market cap would make it one of the biggest companies in the index, but the index gatekeepers – S&P Dow Jones Indices – have not yet given Tesla the green light.

S&P Dow Jones have rules which must be followed to allow admittance in to the index. One of these rules is that a company must have been profitable in their most recent quarter and over the past year before they can be considered. The last loss reported by Tesla was $1.12 per share back in July 2019, so with their latest releases of a positive $2.18 per share, they have now met the Index criteria.

So What does this mean in Practice?

The addition of Tesla to the S&P500 would be a massive event for the fund managers of ETF’s and mutual funds that passively track the S&P500, presenting them with one of the biggest trading problems they will have faced in many years. These managers oversee something in excess of $10trln, which is either tracking the S&P500 or using it as a benchmark. Consequently, if Tesla is added to the index, then these managers must invest a proportionate amount (to Tesla’s weighting in the index) in to Tesla shares whilst selling a basket of the other shares to fund it. One of the simplest ways to execute this strategy is for a fund manager to buy Tesla shares and sell S&P500 futures. A hedge [risk arbitrage] tactic, that allows the manager to capture upside potential, while minimizing downside risk.

The magnitude of the trade is mind boggling – at current levels these fund managers would need to sell around $35-$40 bln of shares to raise funds to invest in Tesla. As a guide, $35bln is equivalent to over 200,000 mini S&P futures contracts and well over 20,000,000 Tesla shares.

When will this Happen?

A good question that a great many people are searching for the answer too. Right now, nobody knows!! Theoretically the addition of Tesla to the S&P500 could happen at any time. E*Trade Financial and Tiffany are both in the acquisition process, so their exit will leave holes in the index that need to be filled.  The index management committee, which meets several times a year (usually quarterly to coincide with futures expiry,) with the next set of changes to be implemented in September. The passive index managers may only get a few days notice to implement this strategy, and they must have a strategy in place – do they start buying before the date of addition, on the date of addition, after addition, dollar cost average over the period, or wait and see. There is no right or wrong answer – but their decision is why you pay them management fees.

Arbitragers and hedge funds and risk traders will be perfectly aware of this situation, and will be seeking to make money. The passive managers need to consider if such risk takers have already been buying stock causing a rise in price, and hoping to profit from selling in to the demand of the index trackers.The ultimate caveat for S&P Dow Jones is that there is no obligation for them to add Tesla to their benchmark. However I believe that Tesla will be joining the index, and sooner rather than later.

How do I Trade this Event?

This is the $64,000 question as there are so many variables: timing, passive traders, risk traders, exterior market events and so on. However if, as I expect, this does occur, we can expect to see a glut of buyers in Tesla shares, with some of the demand met by the risk traders. I would still expect there to be some upside in the shares. Conversely, there will be selling of other shares in the index. The perfect trade would be to buy Tesla and sell all the others. I am happy to assist you in this but the commission bill could be heavy!

My favourite approach would be to use the options market. Buying an out of the money call will temper the premium paid to participate, whilst selling a shorter dated out of the money put to assist in financing the purchase whilst you benefit from faster decay in the shorter dated option.

As an example, “+1 TSLA 16 OCT20 1600 call” will cost around $151 per contract or $15,100 to trade. To offset this we’d sell “ -1 TSLA 18 SEP 20 1300 put” for around $61 per contract or raising proceeds of $6,100. Net outlay (ignoring commissions) would be around $9,000.

To make money, you simply need Tesla to go up. If they stay exactly where they are, you lose the premium paid, and if they fall below $1300 per share the losses will grow. You can adjust the option strikes for a greater premium outlay and a higher strike call or lower strike put combination or vice versa. Alternatively you could sell more puts to reduce the outlay, but this does increase the downside risk.

The short put strike expires before the long call (18th September as opposed to 16th October) leaving you long a call only after 18th September which wipes out the downside risk.

With RhinoTrader you can build any strategy as a custom strategy and the platform will show market implied pricing. RhinoTrader also has a scenario profile to enable you to view the risk profile of any strategy before you trade

Further Info

To trade this strategy you need to have an account on our RhinoTrader platform email me at gcottis@tvmarkets.com with any questions on the above or for account opening, or if you have an account already please contact your account manager.

To open a new account just follow this link www.tvmarkets.com/gcottis

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Graham Cottis

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