Investors have piled into Tesla, Inc. (TSLA) call options expiring in less than two weeks at an at-the-money (ATM) strike price. A Barchart report shows that volume for this contract is over 223 times normal.
That is one of the highest ever volume/outstanding interest ratios we have ever seen. It implies that some investors see TSLA stock as undervalued.
TSLA closed at $426.01 on Friday, May 22, up almost 2.0%. Since releasing its Q1 earnings a month ago, TSLA stock has risen 9.9% from $387.51. It's up over 24% from a pre-earnings trough of $343.05 on April 8, but down from a recent peak of $445.27 on May 13.
This unusual call option volume implies that many investors think TSLA stock could move higher.
This can be seen in today's Barchart Unusual Stock Options Activity Report. It shows that over 35,000 call options have traded at the $427.50 call option strike price for the period ending June 5, 13 days from now.
As mentioned, this volume is over 223 times the prior number of contracts outstanding, 157. In other words, some institutional investors have piled into this two-week call option contract.
The premium paid was $13.30 at the midpoint, which means buyers expect that TSLA will rise to at least $440.80, or 3.47% higher:
$427.50 strike price + $13.30 = $440.80
$440.80 / $426.01 trading price = 1.03472 -1 = +3.472% higher breakeven
The point is that buyers of these calls expect TSLA to spike from here, whether or not they intend to exercise the call options.
The delta ratio is over 50%, implying a very good chance that this will occur.
On the other hand, sellers of these calls, especially when done on a covered call basis, make a good return: $13.30/$426.01 = 3.12% for 2 weeks. If this can be repeated, it implies a 6.24% monthly yield. That is very attractive to short-sellers.
Moreover, even if TSLA rises to 427.50, investors would earn a slightly higher return, due to the capital gain (i.e., 3.47% total return).
Let's look at why investors are willing to buy TSLA stock here.
Is TSLA Stock Undervalued?
Tesla's revenue rose 16% YoY but fell 10% from Q4 and is down 20.3% from peak revenues in Q3. Nevertheless, its gross margin has risen to a peak of 21.1%, its highest so far, and its adjusted EBITDA margin (a cash flow measure) is also at a peak 16.4%.
However, due to heavy capex, free cash flow has fallen to $1.444 billion, well below its Q3 peak of $3.99 billion. Nevertheless, this still represents a strong FCF margin of 6.45%. That beat last quarter's 5.70% FCF margin, and was 88% higher than last year's 3.43% margin.
The point is that the company is squeezing out more cash from its operations as revenue rises. That implies that future FCF could be higher as analysts forecast higher revenue.
For example, analysts surveyed by Yahoo! Finance now expect this year's revenue to rise 7.86% to $102.28 billion and to rise 15.6% next year to $118.14 billion.
That implies its FCF could rise to between $6.6 billion and $7.62 billion using its recent 6.45% FCF margin. The average is about $7.11 billion.
As a result, using a 1.0% FCF yield metric, typical for technology stocks, it implies TSLA could be worth $711 billion. Even with a much higher valuation metric of 0.5% FCF yield:
$7.11b / 0.005 = $1,422 billion, or $1.42 trillion
That is still below Tesla's market cap today of $1.6 trillion, according to Yahoo! Finance.
In other words, TSLA stock is overvalued by 11.1% (i.e., $1.422 trillion / $1.6 tr -1), implying TSLA stock is worth just $378.61 per share.
Yahoo! Finance's survey shows that the average analyst price target (PT) is $411.89, and Barchart's mean survey PT is just $401.77.
The bottom line is that TSLA stock looks overvalued, unless its FCF margin rises dramatically over the next two years.
What This Means for the Unusual Call Options Activity
As a result, investors in these call options may simply be looking to ride a momentum wave, not based on a fundamentally undervalued situation. They may be hoping to sell their call options at a higher price if TSLA's recent spike continues.
Moreover, call option sellers are making a very good return here, as shown above.
Either way, most investors should realize that this is a highly speculative bet, either way. The risks of loss, from either selling these calls (i.e., if TSLA falls below the income gained), or buying them, are very high.
On the date of publication, Mark R. Hake, CFA did not have (either directly or indirectly) positions in any of the securities mentioned in this article. All information and data in this article is solely for informational purposes. For more information please view the Barchart Disclosure Policy here.
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