Limiting Losses On Tesla Stock

| About: Tesla Motors (TSLA)

Summary

Last August, we noted potential headwinds for Tesla, and posted an optimal collar hedge Tesla shareholders could use to limit their downside risk to 11.6%.

Tesla shares are down 18.6% since, but investors protected with the hedge were down 7%, as of Monday's close.

We review a few current concerns and discuss courses of action for hedged Tesla shareholders.

August And Everything After

In late August, we noted a few possible headwinds for Tesla Motors (NASDAQ:TSLA), suggested investors might want to add some downside protection to it, and offered an optimal collar hedge to accomplish that (Adding Downside Protection To Tesla). Since then, Tesla shares are down 18.6%, as of Monday's close. In this post, we update the status of that hedge, and consider the courses of action available for hedged Tesla shareholders, in the face of a few notable current concerns. First, let's review a few previous headwinds and current concerns, then we'll take a look at the hedge, its current status, and consider possible courses of action.

Previous Headwinds And Current Concerns

One of the concerns we noted back in August was the bear market in oil, lowering gasoline prices, and making Tesla's expensive electric vehicles relatively less attractive (the photo of the gas prices above was taken by the author at the Teterboro, NJ Costco (NASDAQ:COST) on Saturday). Back then, West Texas Intermediate crude oil had just broken below $40 per barrel. As of Monday, WTI Crude (Feb 16 contracts) had dropped almost another $10, closing at $30.62, per Bloomberg. As Bloomberg's chief energy correspondent, Javier Blas, pointed out on Twitter (NYSE:TWTR) early Tuesday, there's little hope of an OPEC emergency meeting breaking the slide:

Another potential headwind we mentioned in August was the prospect of increased competition in the future by one of Tesla's former customers, Daimler (OTCPK:DDAIF), as shared by Seeking Alpha contributor Anton Wahlman at the time. Wahlman warned again about increased competition in a more recent article, reporting from last week's Consumer Electronics Show. His key takeaways were that major automakers, most notably GM (NYSE:GM), with its Chevy Bolt, were coming out with long-range electric vehicles with self-driving capabilities that would offer stiff competition to Tesla, as early as later this year.

My key takeaway, from reading the FT's reporting on CES ("A New Direction of Travel") over the weekend was the possible implications of the deal between GM and ride-sharing start-up, and Uber (Private:UBER) competitor, Lyft (Private:LYFT):

General Motors announced a $500m investment in Lyft, the ride-hailing app that is trying to mount a global challenge to industry leader Uber. Apps like Lyft could one day pose a mortal threat to the car industry: should they replace vehicle ownership on a broad scale and turn cars into interchangeable shared utilities, companies like GM would lose their direct relationship with many customers.

The writers seem to have pulled their punch at the end of that paragraph: "mortal threat" is followed by "would lose their direct relationship with many customers." Obviously, the directness of the customer relationships isn't the "mortal threat;" the mortal threat is that they would sell a lot fewer cars, particularly when you combine the impact of ride-sharing and self-driving cars.

Cut out the cost of paying drivers, and the cost of using ride-sharing apps will drop significantly, prompting more potential car customers to eschew buying cars and use ride-sharing apps exclusively. And without drivers, the same car can be on the road close to 24 hours per day (with breaks for cleaning, fueling, and minor maintenance).

Another current concern relates to the state of the markets more broadly. As we noted in our previous article, George Soros warned that 2016 could be another 2008, based mainly on his concern that troubles in China could spillover to the rest of the world. And now The Royal Bank of Scotland (NYSE:RBS), via Western Australia Today, has weighed in with its own warning, "RBS Tells Investors: 'Sell Everything'".

Given all these current concerns, and the slide in Tesla shares since August, it's been a good time to be hedged. Let's take a look at our August 19 Tesla hedge and its status as of Monday, January 11.

A Look At The August 19th Tesla Hedge:

The screen captures of the hedge above were taken from the Portfolio Armor iOS app. As you can see at the bottom of the screen capture directly above, the net cost of this collar was negative, meaning the investor would have collected $900 more from selling the call legs of the collar than he paid for the put legs. To be conservative, that cost was calculated assuming the investor bought the puts at the ask, and sold the calls at the bid; since an investor can often buy puts for less (at some point between the bid and ask prices) and sell calls for more (again, at some point between the bid and ask), an investor opening that hedge on August 19th would likely have collected more than $900 for doing so.

How That August 19th Hedge Has Responded To Tesla's Slide

Here is a quote on the put leg of that collar as of Jan 11.

And here is an updated quote on the call leg as of Jan 11.

How That Hedge Protected Against The Drop

TSLA closed at $255.25 on Wednesday, August 19. A shareholder who owned 1,000 shares of it and opened the collar above then had $255,250 in TSLA stock plus $18,950 in puts, and if he wanted to buy-to-close his short call position, he would have needed to pay $19,850 to do that. So, his net position value for TSLA on August 19 was ($255,250 + $18,950) - $19,850 = $254,350.

TSLA closed at $207.85 on Monday, January 11, down 18.6% from its closing price on August 19. The investor's shares were worth $207,850 as of January 11, his put options were worth $29,800, and if he wanted to close out the short call leg of his collar, it would have cost him $1,220. So: ($207,850 + $29,800) - $1,220 = $236,430. $236,430 represents a 7% drop from $254,350.

More Protection Than Promised

So, although TSLA had dropped by 18.6% at the time of the calculations above, and the investor's hedge was designed to limit him to a loss of no more than 11.6%, he was actually down only 7% on his combined hedge + underlying stock position by this point.

Courses Of Action For Hedged Tesla Shareholders

Being hedged gives an investor breathing room to decide what his best course of action is. A TSLA investor hedged with this collar could exit his position with a 7% loss now (instead of an 18.6% loss), he could wait to see what happens, or if he remains a long-term bull, he could buy-to-close the call leg of this collar, to eliminate his upside cap. If he's even more bullish, he could sell his appreciated puts, and use those proceeds to buy more TSLA.

When backtesting the hedged portfolio method, we tested variations of the first two of those four scenarios. Specifically, we looked at securities that fell below the decline threshold we hedged them against (which was 11.6% in the case of Tesla in our example above), and whether, on average, hedged portfolio performance was better if those losing positions were exited three months into the duration of the portfolio, or held for six months, or until just before their hedges expired, whichever came first. We found that, on average, investors were better off holding their losing positions for six months or until just before their hedges expired, whichever came first.

Tradeoff: Time Value Versus Time for Recovery

The tradeoff involved there is this: The longer you hold the position, the more time the price of the underlying security has to recover. On the other hand, the sooner you exit the position, the more time value your in-the-money put options have (time value is why the TSLA hedge offered more protection than promised in the calculations above). In our hedging method, we aim for options with approximately six months to expiration, and select the closest available. In the case of TSLA in late August, those were options expiring in mid-March, about seven months out.

We mentioned a few different current concerns for Tesla shareholders above, ranging from low gas prices, competition from other automakers, disruption to the industry that could eventually result in far fewer cars sold, to the broad market warnings by George Soros. The question for TSLA shareholders hedged as above now is what is likely to move the stock by mid-March. The CES news is likely already priced into the stock, and the questions about industry disruption won't be resolved before this hedge expires. If you share the views of Soros and RBS, you'd want to exit your position now for a ~7% loss, regardless of your view on the other concerns. If you're sanguine about the broader market, then your decision will center on how bullish you are on the company's next earnings release (which hadn't been announced as of Monday, but was on February 11 last year).

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.