Tesla's S&P 500 Inclusion Part 3: The Final Chapter

Previous installments:

• Tesla's S&P 500 Inclusion: Predicting TSLA's post-inclusion stock price
• Tesla's S&P 500 Inclusion Part 2: Predicting the transformation of the TSLA float

Options market and delta hedging knowledge:

• The TSLA Options Market is an order of magnitude larger than any other
• The Mechanisms That Fueled TSLA's Meteoric Q1'20 Rise (chapter 4)
• Tesla's S&P 500 Inclusion Part 2: Predicting the transformation of the TSLA float (chapter 5)

Table of Contents:

1. Introduction
2. 3:00PM - 3:50PM
3. The Closing Cross
4. After Hours Trading
5. TSLA Going Forward
6. Final Thoughts

1: Introduction

I finished writing about half of this post, and then as I came to better understand what transpired on Friday, I deleted everything, and now I am starting again from scratch.

I stayed up for 36 hours straight from Friday morning Singapore time to Saturday night Singapore time, and I've spent 80-90% of my time on TSLA since the S&P announcement. Moreover, I spent basically 100% of my time on TSLA during the first week after the announcement and during this past week leading up to the inclusion. For the next six months, I'm probably going to be swamped after my INSEAD MBA program starts in two weeks, and I could really use a break before then, but with a bunch of real-life stuff that needs taking care off, I'm not sure if I'll manage to fit in any off-time.

Basically, I'm quite exhausted and busy, so with all of this in mind, I'm going to keep this as brief as possible.

2: 3:00PM - 3:50PM

TSLA traded fairly steadily for most of Friday. There was likely some buying, speculating, and profit taking during the first two hours, but after that the day was pretty uneventful until 3PM. The explanation of what started the events around 3PM likely lies in something pointed out by Sudre on TMC:

3:47AM Singapore time - 2:47PM Eastern time

During Friday, I was on the phone with IBKR for half of the day, because I needed to ask them if I could hold my ITM $650 18Dec call options until expiration, so that I could sell them during the final minutes before market close. However, because the position was too large for me to exercise, IBKR wouldn't let me hold it until expiration no matter what, and they told me they would liquidate it automatically around 3:45PM. As a result, I closed out the position myself throughout the day, luckily enough before the 3PM events started.

What Sudre is referring to in his post is the time that Robinhood starts to liquidate ITM options positions of its users, who have insufficient margin to exercise those options. This time turns out to be around 3PM. MMs (market makers) then sell delta hedge shares associated with the liquidated positions, which puts downward pressure on the stock price. It's likely that similar things happened at other brokers during the last hour of trading, and that eventually traders and panic sellers amplified these downward movements.

TSLA Options Chain from Thursday

But likely the biggest contributor of all to the 3PM - 3:45PM drop was delta hedging, because there were likely still a lot of open ITM options positions that the MMs were delta hedging. As the price dropped, and these positions went OTM, MMs likely had to sell shares used to delta hedge these positions. Especially so close to expiration, the delta of near the money and ATM options changes very rapidly.

Another reason why it probably dropped so rapidly, between 3:30PM and 3:45PM specifically, is that most entities looking to play TSLA's S&P 500 inclusion should've already been positioned well ahead of time, so there might've been less money available to 'buy the dip'.

Before we talk about the final ten minutes of trading, it's useful to consider who might've bought the shares sold during 3:00PM and 3:50PM. It's hard to give a definitive answer about who the buyers were, but I'd guess they were mostly institutions who had information about what would transpire between 3:50PM and 4:00PM, and after 4:00PM. It's likely that, by this time, index funds had already placed their orders with their brokers for the closing cross. So it's likely that various brokers had an information advantage and heavily bought at those prices, planning to supply these shares to indexers during the cross and/or during AH.

3: The Closing Cross

Now let's try to dissect the final 10 minutes of trading, and the closing cross. I was watching it live, but TMC user saniflash was helpful enough to post a video recording on YouTube as well, which we can analyze:

First of all, it seems like nobody in the TSLA community (including I before this weekend) truly understands the closing cross. Here are what I see as the most misunderstood aspects:

Reference Price

This is a price in the Nasdaq Inside (in between the bid and ask) at which most shares would be paired. So this will always be very close to the price at which the stock is currently trading.

Paired Shares / Auction Volume

The number of shares that can be paired off at the reference price. So IF the auction happened at the above mentioned reference price, inbetween the bid and ask, this number of shares would be paired off. This only includes closing cross orders (market on close, limit on close, imbalance-only).

Imbalance

This is the single most misunderstood part. This is the imbalance at the aforementioned reference price. A 10M+ share imbalance does not mean 10M+ shares can not be paired off, it means 10M+ shares can not be paired off at the reference price.

Far Indicative Clearing Price / Closing Only Match Price

This is the price at which the closing cross would happen at that point in time based only on closing cross orders (MoC, LoC, IO). No mention is made of what the imbalance would be at this price.

Near Indicative Clearing Price / Auction Price

This is the price at which the closing cross would actually happen at that point in time. This includes not just closing cross orders (MoC, LoC, IO), but also orders currently present in the continuous order book. If the Far Indicative Price is at $750, the stock is trading at $650, but somebody enters like 200M regular limit sell orders at $700, the Near Indicative Price would likely end up being $700, because it will also include these non-closing cross orders. The actual closing cross also includes non-closing cross order types, because it merges both the closing cross order book and the NASDAQ continuous order book.

With this in mind, there are a few take-aways we can make from the video:

• There were ~72.5M closing cross buy orders willing to buy at <$680. At $695, it appears this number was lower at 69M. Meaning there were a few LoC buy orders with limits between ~$680 and ~$700.
• There likely were 48.5M MoC sell orders, unless some of these sellers had LoC sell orders with limits below $640.
• There were likely some LoC sell orders with limits at $650+. This is part of what reduced the imbalance as the reference price ran-up, and sometimes increased the imbalance as it went down.
• There also likely were some traders taking advantage of this arbitrage opportunity, but not enough to close the gap between the stock price and the Near Indicative Clearing Price.

69M shares ended up being traded during the closing cross. There was almost certainly an imbalance, but we do not know whether it was a buy-side or a sell-side imbalance, and we do not know the amount. The imbalance and paired shares reported by the NASDAQ at the end is what the imbalance and paired shares would've been, if the closing cross had happened at the Refence Price of $661.96.

Price Action 3:50PM - 4:00PM

Now, you might wonder what was up with the weird price action, and why it wasn't going up more, in spite of a large imbalance being reported at market prices. I think the following factors are what caused this:

1. Due to the massive amounts of money involved, and the amount of money already invested in front-running this inclusion, I believe there wasn't enough money available in the market to make it work perfectly. I believe there weren't enough billions of dollars watching TSLA during those 10 minutes to take advantage of the arbitrage opportunity.
2. I believe that more ITM options were being liquidated by brokers on behalf of clients who had insufficient margin to exercise them. It's also likely that speculators, who couldn't afford to exercise their options positions, either liquidated them, or shorted the stock to lock in gains. If you own a $650 call expiring in 5 minutes, and you can't liquidate the position, you can short the stock at $670 and cover by exercising your options. ITM options positions being liquidated in massive amounts might also help explain the large strange drops in options premiums near close on Friday.
3. I believe that some of the biggest players might've been incentivized to not sell during the closing cross, thereby artificially inflating the closing price, allowing them to sell for higher prices to index funds during after hours. Imagine you have 15M shares you want to sell to indexers, and you see the massive imbalance. Are you going to put in an on-close sell order and drive down the price, or are you going to keep your shares and sell them for more during after hours in block trades at a higher closing price?

I think these three factors explain the, at first sight, seemingly illogical price action during the final ten minutes.

4: After Hours Trading

After going through some VWAP data on Market Chameleon, and after looking at the NASDAQ after hours volume chart, it seems to me that out of the 47M after hours volume, ~8M were regular trades, and almost 40M were massive block trades (I saw many 999,999 block trades come through @ $695).

https://marketchameleon.com/Overview/TSLA/VwapTable/AfterHours

https://marketchameleon.com/Overview/AAPL/VwapTable/AfterHours

https://marketchameleon.com/Overview/BABA/VwapTable/AfterHours

Actual AH volume for these three stocks:

• TSLA - 47.1M
• AAPL - 15.31M
• BABA - 1.26M

You can see that Market Chameleon is quite accurate for BABA, less so for AAPL, and not accurate at all for TSLA. I believe that it got tripped up by massive after hours block trades not at market prices, and did not count a lot of these. TSLA should've had the most of these block trades, AAPL less, and BABA not being in the S&P 500 very few.

Out of the 10.5M TSLA volume, it seems like ~7.5M was at normal market prices and ~3M at $695. Assuming the 36.5M missing volume is all at $695, that'd give 39.5M volume at $695 during after hours.

Looking at this after hours TSLA chart, it looks like the first hour consisted of a lot of people buying up shares to sell off to indexers at $695 in dark pools and block trades. I'd guess sellers were more people with call options expiring at $650-680 shorting the stock, or their brokers doing it for them, because they can exercise their options until 5:25-5:30PM.

5: TSLA Going Forward

If we revisit my model from part 2 of this series, account for the public offering, and update all the figures, we get this:

If this is more-or-less the end of the buying, my model predicted buying almost perfectly. My model predicted 38.6M + 67.9M = 106.5M, and actual buying ended up being 69.3M + 39.5M = 108.8M.

Although my model predicts that at this point in time supply should've been short by 29.2M shares, it's not inconceivable that these shares came from somewhere. It's possible that some shareholders have wanted to divest from TSLA for some time, but were waiting for 'the S&P inclusion bump' to do so. Jennison Associates LLC, and some of Capital World Investors funds, such as American Funds Insurance Series and New Perspective Fund, are good examples of this. These investors all have well over 5% of their AUM in TSLA, and might've been waiting for this opportunity to divest a little. If investors like this divested somewhat more than my model predicted, this could probably account for 10-20M shares.

Furthermore, there are the ~60M shares that went missing during Q3, which may have been scooped up by Softbank, Berkshire Hathaway, or some other entity. My model did not account for any sales from this potential mystery investor. If it exists, and it decided to sell (some) for a quick 100% profit @ $695, this could also help explain this 30M gap.

Where do we go from here?

Although the current $650-700 is near the bottom of where I expected TSLA could settle post-inclusion, I nonetheless converted all my options to shares at market open this Monday. My long-term options I would've sold months ago at $2,000-2,500 if not for the looming S&P inclusion, because they were so deep ITM that there was little upside left. My short-term options had grown into an uncomfortably large percentage of my portfolio, and 98% of them were expiring in 4 trading days.

There are a lot of reasons to be bullish on TSLA in the near-term:

• There shouldn't be too many investors left looking to divest near-term. I think just about everybody who wanted to do so, got the chance to do so at $695.
• TSLA settled at a price and valuation that really isn't all that unreasonable. Financials and growth in a year from now, and continued FSD development could easily provide 50% upside over the next 12 or so months. Unlike if we had settled at $1,000+, I think TSLA can continue to go up slowly but surely.
• There could still be S&P buying left. I think probably most of it has finished, but even if just 10M shares are left, that's still a lot of buying pressure.
• Benchmarked funds might buy dips below $695, because it's an easy way to outperform the S&P 500.
• Year-end window dressing.

But I nonetheless decided to sell my short-term options because:

• With so many expiring in just 4 trading days, a big macro crash or something along those lines would really hurt. It's already unfortunate macros are down a few percent today, and my options would lose 80% of their value, if the stock somehow dropped further to $600.
• Although there could be S&P buying left, there could not be. For me, it's hard to say either way at this point.
• I believe there's still some money betting on the S&P inclusion in the form of near-term call options. Mostly 24Dec expiries, but likely also some 31Dec and January expiration call options. These could cause a dip if owners take profits.

All in all, I believe TSLA is a lot more likely to go up (slightly) than down over the next 3-6 months, but the next week is kind of a gamble at this point in my opinion, which is why I converted all my short-term calls to shares.

6: Final Thoughts

This marks the first time in ~19 months that I no longer hold any TSLA call options. I'm happy to hold 100% common stock now, because it'll be less stress, and it'll allow me to focus on my MBA next year and other more important things in my life.

I'll likely still follow Tesla, but I'll spend a lot less time on it. I think everything I laid out in my Tesla Investment Thesis 2.0 a year ago still holds true. I believe Tesla is still drastically undervalued, and I struggle to come up with scenarios where Tesla does not dominate transportation in 10-15 years. In my eyes, they'll be:

• Selling and managing massive fleets of AEVs (Autonomous Electric Vehicles)
• Leading the conversion of the ways in which the world generates and stores energy from unsustainable to sustainable
• Working with The Boring Company to expand a new form of transport through tunnels
• Building electric airplanes, and perhaps also electric boats
• Selling top-notch cloud AI computing ala Dojo
• Various other smaller lines of businesses, such as HVAC

Going forward, I'll likely spend more time on other things, and less time on Tesla. For the time being, I think I'll only concern myself with changes to this long-term thesis. If something happens that significantly impacts this long-term thesis for the better or for the worse, I'll take note, but otherwise I'll just spend my time on things more important to me.

Personally, I can sleep well and be stress free, being invested in the future in the form of TSLA common stock, and knowing Elon and Tesla's amazing employees are doing their bests to make the world a better place.