Hedge Funds May View Tesla's S&P Sell-Off As A "Negative Catalyst"

Tesla faced what appeared to be its first reality check in years in trading on Monday. After being included into the S&P 500 index, Tesla shares finished the day down 6.49%, falling $45 per share amid a coming implied volatility collapse and a liquidity triggered “normalization” that very well could prevent Tesla from being pushed higher by call option buys, they way it has been over the last year or so.

Roth Capital Partners analyst Craig Irwin told Bloomberg on Monday that the sell off could be considered a negative catalyst: “Hedge funds will treat this as a negative catalyst for Tesla given buying pressure eases off very quickly.”

Bernstein analyst Toni Sacconaghi had also noted in early December: “There is strong precedence for positive returns for stocks prior to S&P 500 inclusion and post announcement, but very limited precedent for near term outperformance post inclusion.”

In other words, the gravy train could be coming to an end. 

This comes after a flurry of institutional investing on Friday that culminated in almost $60 billion in stock changing hands at a price of $695. Throughout the entire session, more than $150 billion in Tesla shares traded hands. 

Tesla stock wasn’t helped along much on Monday when we noted that Apple was throwing its hat into the self-driving car business. Tesla shares slipped to their lowest of the day on the news, while Apple shares perked up to their highs of the day. In addition to designing self-driving vehicles, Reuters also reported that Apple’s cars could “include its own breakthrough battery technology”.

Apple’s development project, called “Project Titan” was rumored to have been shelved after first starting in 2014. However, former Tesla executive Doug Field returned back to Apple in 2018 to work on the project before laying off 190 people from the team in 2019. But since then, “Apple has progressed enough that it now aims to build a vehicle for consumers”, Reuters noted.

It is also worth noting that a couple days before Tesla was included into the S&P index, we published Twitter user @Squeezemetric’s astute analysis, which made a cogent case as to why Tesla stock could potentially fall as a result of its inclusion in the index. 

How S&P inclusion bursts the Tesla bubble:

Ever since June (at $200/share), Tesla stock has been driven by a perpetual motion machine of hype and call option flows — nothing more. And everyone knows it.

Here’s what not everyone knows:

  • When a stock joins the S&P 500, it becomes part of a massive volatility complex, which is a terrifying web of arbitrage and pseudo-arbitrage relationships. Tesla will join the index as a top-ten component of a cap-weighted index. It’s big.
  • Its bigness will allow all manner of dispersion, relative value, and market-making traders to begin relying on Tesla’s newfound correlation to the index. This will invariably cause arbitrageurs to buy SPX options/vol and sell TSLA options/vol to “close the spread.”
  • Since Tesla stock is driven by the returns on call options, it is a slave to “vanna”: the relationship between option prices (implied volatility) and delta (stock exposure).

In other words, since June, $TSLA goes up only when implied volatility (IV) goes up (purple line is IV).

When Tesla joins the index, these historic call option flows and the hype machine behind them will hit the big red fire truck that is the S&P, at 500mph.

Implied volatility will be unable to rise. Call options will bleed value. New flows will be absorbed by real traders.

With the call option hype trade hampered, the stock will have no possibility of further returns — a deliciously ironic end to the ugliest of Robinhood’s many ugly children.

And an appropriately ironic fate for Tesla – a victim of its own “success.”

However, noting Craig-Hallum’s comments, if this scenario does begin to play out and hedge funds do choose to unload Tesla – whether out of fear of “normalization” or motivation to outperform the very same index Tesla is now part of – we could be moving on from the call option renaissance period for Tesla and into an entirely new trading zeitgeist for shares.

We’ll be waiting with bated breath for the next twist in the saga…