Monday 13 January 2020

Navigating the Options Cycle on Tesla

Tesla is one of the most volatile large cap stocks in the market. It's a battleground stock with the war between longs and shorts waged in each buy or sell order, and each resulting fluctuation of its stock price. In about a year the price has gone from $377 in December 2018, halving to $177 in June 2019, subsequently tripling to close at $525 most recently on the 13th of January 2020.

The stock war is waged not just in the direct purchase or sale of the stock, or in the media, but in the options market too, where insufficient attention is paid by the ordinary investor, and where much descriptive value may be found. The options market can exhibit reflexivity, a circular relationship between cause and effect. The strike price of price of an option can act as a magnet pulling the underlying stock price, creating a virtuous, or vicious, cycle depending on where you have placed your own bets. The options activity in Tesla is unique in several respects, and understanding this will aide understanding of the volatility in the underlying stock price.

According to the Options Clearing Corporation the open interest in put options on Tesla stock amounted to 160 million units on the 13th of January. This is more than the number of shares in Tesla's float, an unusually large number of open options that suggests a large degree of influence over the underlying stock. There were 80 million call options on this date for a 2:1 Put-Call ratio. This is in contrast to an approximate 1:1 Put-Call ratio across the market and suggests a high degree of bearish sentiment toward Tesla stock.
The Put-Call ratio is a common, albeit crude, measure of investor sentiment. In the case of Tesla it is is significantly misleading, as less superficial analysis will reveal. Not all options are created equally and not all options should be weighted equally.

Two of the key factors in the relationship between a call or put option and the underlying stock price are the strike price of the option, and the expiration date. This is where two important facts will emerge.

1) Most put option volume on Tesla stock is currently deep out of the money, and most call option volume is in the money, as the following volume chart segmented by option strike price reveals:
Based on the 13th of Jan closing price of about $525 per share of Tesla stock, more than 99% of put options are out of the money, and 65% of call options are in the money.

2) Nearly half of call and put option volume expires on the 17th of Jan, as the following volume chart segmented by option expiry date reveals:
This means that there is only a narrow window of time remaining for movements in the underlying stock price to effect the intrinsic value of the outstanding options.

Combining the above facts under the assumption that counterparties have hedged their exposure, we can determine what has been the impact to the underlying stock demand of these contracts, and how this might change in response to changes in the underlying stock price. Options pricing theory provides just such a mechanism - Delta Hedging. For our purposes the most important thing to know about Delta Hedging is that the more likely an options contract is to be exercised, the greater the number of underlying shares the counterparty to that contract needs to transact in to hedge their exposure.
The chart above contrasts the gross number of options reported with the number of underlying share transactions that would currently be required to offset counterparty exposure to that option contract. The 80 million call options equate to 50 million share purchases. The 160 million put options equate to 5 million short sales.

The same options pricing theory that provided us with Delta-Hedging, the Black-Scholes model, also provides a mechanism to calculate the value of the call and put options, and the calculated values of these options track closely to recent trade prices of those options. This implies this is not simply a theoretical exercise but has some basis in reality with regards to the any underlying share transactions to offset the exposure on these options, and the observed activity in Tesla stock.

It's important to recognise that the number of shares required to offset an options position is not static and changes, most importantly, with the price of the underlying stock. The following chart shows the Delta Hedged volumes segmented by different underlying stock prices:
The chart shows that between the underlying stock price of $500 and $525 the number of share purchases required to offset the call position increases from 45 million to 50 million as more call options are deeper in the money and more likely to be exercised. Conversely, the number of short sales required to to offset the put position reduces from 8 million to 5 million as more put options are deeper out of the money and less likely to be exercised. This equates to a net increase in demand for Tesla stock of 8 million shares. Such a price move therefore induces as much demand for Tesla stock as the third largest institutional investor in Tesla, the Saudi Public Investment Fund, has accumulated over time.

The actual stock price increase of $47 on the 13th of Jan is enough to stimulate demand for nearly 17 million shares of Tesla stock, more than the single largest institutional investor in Tesla, Baillie Gifford, has accumulated, and all in a single day. This reflects a virtuous (or vicious) cycle where a stock price increase induces further demand for Tesla stock which all else equal will push the price up further as further counterparty share purchases are required to offset their options exposure. The reverse is also true, as a reduction in the share price would have the exact opposite effect. This self-reinforcing cycle explains the volatility and periods of momentum we have seen in Tesla stock to a significant degree, but there are caveats. There will be differences in timing and extent to which counterparties hedge their exposure. And other factors influence the stock price too, principally market participants deciding whether to continue to participate, or to place their chips elsewhere.

- Vincent

[Disclosure: long time holder of Tesla stock]