Tesla Hedge Holds Up As Stock Tumbles

| About: Tesla Motors (TSLA)

Summary

In August, we noted potential headwinds for Tesla and posted a hedge to limit investors' downside risk to 11.6%.

Tesla shares are now down 42% since then, after Monday's 9% drop, but investors protected by that hedge are down 11.5%.

We update the status of the August hedge, discuss courses of action for hedged Tesla shareholders, and present an updated hedge to show how option sentiment has soured since.

Tesla Shares Fall To Two-Year Low

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). A month ago, we wrote that hedged TSLA shareholders who agreed with warnings from George Soros and RBS about broader market risk should exit then for a 7% loss, while those sanguine about broader market risk could wait for earnings, knowing that their downside risk would be strictly limited to 11.6% in the worst-case scenario. Since then, Tesla shares have tumbled further, and after Monday's 9% drop, are down 42% since we posted that hedge in August.

In this post, we update the status of that hedge, and consider the courses of action for hedged Tesla shareholders, and post a new hedge using similar parameters to show how option market sentiment has soured on Tesla since August.

Given the steep slide in Tesla shares since August, it's been a good time for Tesla shareholders to be hedged. Let's take another look at our August 19th Tesla hedge and update its status as of Monday, February 8th.

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 February 8th.

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 $147.99 on Monday, February 8th, down 42% from its closing price on August 19. The investor's shares were worth $147,990 as of February 8th, his put options were worth $77,200 at the bid, and if he wanted to close out the short call leg of his collar, it would have cost him $210. So: ($147,990 + $77,200) - $210 = $224,980. $224,980 represents a 11.5% drop from $254,350.

Protection As Promised

TSLA had dropped by 42% 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%, and he was actually down 11.5% on his combined hedge + underlying stock position by this point.

Courses Of Action For Currently 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 an 11.5% loss now (instead of a 42% 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 when we look at it last month; now most of that time value is gone.). 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. And this point, TSLA investors who hedged with the optimal collar above might as well wait to see what upcoming earnings bring. In the worst case, their downside will be strictly limited to within 0.1% of the February 8th closing value of their stock + hedge.

An Updated TSLA Hedge

The hedge below uses the same parameters as the one above, but expires in September. I am posting this because I think the difference in hedging cost versus August is interesting, as it gives an idea of how option sentiment on the stock has soured since.

As you can see in the first part of the new collar above, the cost of the put leg as a percentage of position value, 17.03%, is 2.3x as high as it was in the collar we first posted in August. And as you can see in the second part of the collar below, the income generated from selling the call leg, as a percentage of position value, is 11.28%, which is about 1.4x what it was in the collar posted in August.

So, the net cost of this collar was 5.74%, compared to a net cost of -0.35% for the collar posted in August.

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.