How can an option trade make 4000% in one day? Tesla stock has been highly volatile and one of the drivers of this volatility is the unusually large volume of options trading. Are large proportion of Tesla option contracts are traded on the day of expiration (zero DTE) and just out of the money. This allows speculators maximum leverage and the small possibility of a significant profit.
Hi and welcome back to Reflections on investing with the Cornell Capital Group. I think we have a particularly interesting one today. Remember that in previous Reflections I've talked about a distinction that my colleague Aswath Damodaran and I often make between the pricing game and the value game.
As we've described this in published papers the pricing game depends on supply and demand for a stock or in this case an option. That supply and demand in the short run can be dramatically affected by mood, sentiment and momentum.
On the other hand there's the value game, which is the true long-run value of a stock that depends on future cash flows and the rate at which they're discounted.
At the Cornell Capital group we focus on the value game, we're looking for situations where we believe the long run value of the company diverges from the price.
But why would it diverge? The answer to that would be the pricing game, short-term speculation based on sentiment and momentum.
But how common is that? Is there really an active pricing game or is this some sort of theoretical thing that professor Damodaran and I speak to?
Well I think you can answer that question by looking at the options market. Let me review quickly what an option is and we'll be talking here about call options. A call option is a security that gives you the right to buy a stock at a specific price, on or before a specific date.
For example, the Tesla 150 call options of January 27,2023 gave you the right to buy Tesla at 150 a share on or before January 27 2023. So with that background let's look at some of the Tesla options.
If we bring up the the spreadsheet you can see that I have three Tesla options here and all these mature on January 27th 2023. That's the final date, after that date the option expires. We’re looking at the Tesla 175s,the Tesla 150s, and the Tesla 140s all up to that point in time.
The stock price of Tesla is showing in the far right hand column. Now an option is called out of the money when the stock price is less than the option strike price. For example, if the stock price is 170 but the option gives you the right to buy at 175, that's out of the money.
Let's look at the trading in these options and in particular I want to focus on the 175s. Notice that the 175s early on in January the stock price was down at 120 or so.
They're way out of the money, virtually no one is trading them but as the stock price starts to rise it comes closer to the money and by January 26th at the close of the market that day the stock price was 160.
The price of an option to buy it at 175 tomorrow, because that's when it expired was seven cents. Now the next day on January 27th,241,694 contracts for those options traded and each contract is for a hundred shares of the underlying security, so it's effectively like 24 million shares trading. These are options that are called zero day options because they expired that afternoon.
Why would anyone be trading a security that only has a few hours left in its life?
I think the answer to that you can see in the percentage profits if you happen to buy the option on the 26th and then sell it at the close on the 27th.
The stock that day as you can see in the chart was up 11 percent but the 175 options were up 3971 percent! A four thousand percent return in one day. That's almost like a lottery and this seems to happen for just out of the money Tesla options every Friday.
The only reason we can see here at the Cornell Capital Group is that it's a very sophisticated Casino. The fundamental value of Tesla isn't going to change between noon and 3:30 in the afternoon on Friday but hundreds of thousands of contracts will trade in that interval.
What you can take away from this?
There is dramatic evidence of the pricing game in the options market and it's even possible that the tail wags the dog.
Here's what I mean by that. If speculators have a tremendous demand to buy Tesla call options somebody has to sell them.
If that person who sells them is a dealer, the dealer is then short the option butthe dealer doesn't want to be short. So to hedge that short position, the dealer buys the stock.
Well if the stock and option price continue to rise the dealer has to buy more stock in order to keep the hedgeand in this way the option market creates demand for the stock.
The technical term for this process is called a gamma squeeze but you can put aside the technical term. What it means is demand for the option creates demand for the stock.
What's all of this mean for investing?
At the Cornell Capital group we don't have any desire to play the pricing game. As far as we can tell it's outright speculation.
But we do think it can influence the price of the stock and drive it away from its long-run fundamental value. To the extent that that happens, we're not going to enter the pricing game but we'll buy or sell the stock in order to take advantage of that discrepancy and plan to hold it until the discrepancy is eliminated.
Thanks for joining, this has been Reflections on Investing with the Cornell Capital Group.