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The Tail Wags the Tesla Brontosaurus

By:

Chief Strategist at Interactive Brokers

This morning, I was privileged to have a discussion with a reporter about the immense volume in Tesla (TSLA) options.  As an example, Options Clearing Corp (OCC) data shows that nearly 3.7 million contracts traded on Friday alone, compared with share volume of just over 21.6 million.  (Remember that each options contract represents 100 shares.) These are truly astounding numbers when we consider TSLA’s stock price.  According to Bloomberg data, over $26 billion worth of shares changed hands on Friday.   Perhaps it’s not that amazing when we compare the $26 billion share volume to the company’s $816 billion float, but it still means that over 3% of a trillion dollar company changed hands.

It is reasonable to ask whether the huge volume in TSLA options is helping propel the stock higher, in effect is the tail helping to wag the dog.  Since a stock and its options are inextricably intertwined, that is a very reasonable question.  But I propose a different metaphor – TSLA options are the giant tail helping to wag an enormous brontosaurus.

It is helpful to think of TSLA as the ultimate meme stock.   It has all the hallmarks of what we now consider a meme stock – a committed, vocal investor base and a high valuation by conventional measures.  It also shares the tendency to do the opposite of a common market adage – rather than “taking the stairs to the attic and the elevator to the basement”, TSLA shares the meme stocks’ tendency to zoom upward on even a whiff of positive news and to move down only slowly as the news fades or if negative news comes out.  Bear in mind that TSLA rose about 50% in a matter of weeks on the news that Hertz (HTZZ) would be buying 100,000 cars, yet it barely budged when Elon Musk first noted that there was no actual contract between the companies and today when he proposed selling 10% of his shares.  (Twitter poll or not, the IRS is more likely to have the final say about Musk’s stock sales)

The main difference between TSLA and its meme stock counterparts its size.  It is many times the size of the entire meme stock universe combined, no matter how we define memes.  TSLA is now the 5th largest US company by market capitalization, representing about 2.4% of the S&P 500 Index (SPX) and 6.4% of the NASDAQ 100 (NDX).  Like it or not, TSLA has become a behemoth.  It is mind-boggling to consider that a company of such prominence trades so wildly.

While experienced options traders were well acquainted with the propulsive effect of short gamma positions in a rising stock, the term “gamma squeeze” first entered general investment parlance about a year ago.  We saw investors small and large, led notably by Softbank, buying large amounts of out of the money calls in popular stocks last autumn.  The resulting hedging activity by those options’ sellers helped propel already rising shares higher.  We then saw this action writ large in January when the meme stock craze took root. 

Some see a gamma squeeze as nefarious.  It can be, if there is a concerted effort to force a stock higher by a group of call option buyers.  But when a stock is as large as TSLA, with such huge amounts of stock and options volumes, it happens organically.  The first wave of stock and options buyers jump on a piece of fundamental news or a favorable technical setup, then subsequent waves jump on the ensuing momentum.  A feedback effect develops, and it can persist for some time.  I would argue that these types of moves are occurring more often because of the huge increase in investor participation in both stock and options markets, and because in general the moves in shares have been relentlessly upward.

Some have asked why the “gamma squeezes” seem to be asymmetrical – more violent to the upside than the downside.  I believe the explanation lies with the open interest and volume statistics.  When there is an upward surge, many traders prefer to buy out-of-the-money calls than the shares.  Consider the current situation, with TSLA at $1185 and the 1200 calls that expire this Friday are offered at $27.20.  It is understandable why speculators might find it appealing to risk $2,720 to control 100 shares of stock if TSLA advances above $1200 (with a breakeven of $1,227.20) by the end of the week rather than put up $118,500 for a similar exposure.  The call option offers the advantage of a much smaller outlay, a defined maximum loss, and leveraged exposure to the upside.  Under normal circumstances, those advantages are offset by the risk that the option will expire worthless.  During a buying frenzy, the odds could favor the buyer, especially if sufficient buyers follow along.

Thus, if most of the open interest and volume is in above-market options, there is more outstanding gamma that needs to be hedged if the stock approaches those strikes.   Those who are hedging short gamma find themselves needing to “buy high and sell low” as stocks approach the strikes of the options they are short.  Conversely, if the stock dips, there is less gamma that needs to be hedged and fewer traders who need to sell shares into weakness.  Combine that with the willingness of loyalists to buy when the stock price dips, and we see that that there is currently a greater propensity for options gamma to have a greater effect to the upside than the downside. I’m not a paleontologist, so I profess no particular knowledge of a brontosaurus’ tail.  But it is certainly conceivable that a tail so long could in fact wag such a giant beast.  Kind of ironic that I find that the mental image of a huge, lumbering dinosaur offers a metaphor for stock and options trading in a fast moving company that doesn’t rely on dead dinosaurs for its fuel.

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