Why The Tesla S&P 500 Trade Has Become 'Too Crowded'

Benzinga's PreMarket Prep airs every morning from 8-9 a.m. ET. During that fast-paced, highly informative hour, traders and investors tune in to get the major news of the day, the catalysts behind those moves and the corresponding price action for the upcoming session.

On any given day, the show will cover at least 20 stocks determined by co-hosts Joel Elconin and Dennis Dick along with producer Spencer Israel.

For those who don't have the time to tune in live or listen to the podcast, Benzinga will highlight one stock that merits further discussion. This analysis is not a buy or sell recommendation.

Now that Tesla Inc. TSLA second-quarter earnings are out and the automaker has delivered its fourth profitable quarter in a row, the company is eligible to be added to the S&P 500 index.

That topic was discussed in detail Thursday, making it the PreMarket Prep Stock Of The Day.

The Prior Long-Term Trend: For a long period of time, when it was announced that a company was going to be added to an index — and the S&P 500 in particular — the stock would rally significantly until the date that it was officially included.

The reason: any fund that attempted to mimic the return of the index would need to purchase shares of the issue in order to have maintained the same relative performance.

On that other hand, if a company was being dropped from a particular index it would decline significantly until it was officially dropped. The reason for the decline was that fund managers tracking the index had to liquidate their holdings in the issue.

The Times They Are A-Changin': PreMarket Prep co-host Dennis Dick said he used the aforementioned strategy for years: buying the adds and selling the deletes. Yet he curtailed that activity over a year ago, as it was not working as efficiently as it had in the past.

In particular, Dick said he noticed that an algorithm that enacted the strategy in a much bigger and faster way was no longer active. Once again, the reason was that it was not as profitable as it was in the past, and could even result in a significant loss instead of a gain.

Why Did It Stop Working? At the top of today's show, Dick explained the potential reasons why the trade is no longer free money.

The trade had become “too crowded,” he said. In other words, with everyone using the strategy for years, too many buyers pushed the stocks to levels that non-index investors in the issue sold into to take profits or to levels where others initiated shorts.

The secondary reason was that while the issue was being added to one index, it was most likely coming out of another.

As a result, there would be selling pressure on an issue from funds tracking the corresponding index.

The full discussion on the issue from today’s how can be found here: