Hedging Tesla As Social Media Turns Negative Ahead Of Model 3 Debut

| About: Tesla Motors (TSLA)


When Tesla shares were near their low for the year in February, a social data aggregator made a bullish call on the stock.

Tesla is up more than 50% since then, and now social media has turned negative on the stock.

For Tesla shareholders looking to stay long but limit their downside risk, we present two ways of hedging, one of which may be attractive to some longs.

When analysts who are perennially bearish on a stock release a bearish note on it, bulls can be forgiven for taking it with a grain of salt. That's not the case with social data aggregator LikeFolio and Tesla Motors (NASDAQ:TSLA). When shares of Tesla were near their low for the year in February, LikeFolio put out a bullish call on the stock ("Tesla and Elon Musk are ready to win big"). Last week, though, LikeFolio turned bearish on Tesla, based on its reading of social data, as the chart below screen captured from its site indicates.

As LikeFolio elaborated in its post,

We've actually seen a reversal in the social volume for Tesla, as purchase-intent volume has dropped over the past 30 days.

That means (fewer) people are talking about the company's products than they were in Jan and Feb- DEFINITELY not something you want to see leading into a big event (Tesla's upcoming unveiling of its Model 3).

Strengths And Weaknesses Of Social Data

There's a lot of chatter on social media about individual stocks, but a challenge with generating any useful data from it is the tendency of an investor to "talk his book" - anyone who is long a particular stock is likely to make bullish comments about it, and vice-versa. Likefolio attempts to surmount this challenge by mining comments about brands owned by publicly traded companies, rather than the stocks themselves, as the image above from its website illustrates. Someone who comments about Yum Brands (NYSE:YUM) on Facebook (NASDAQ:FB), Twitter (NYSE:TWTR) or other social media platforms may be talking his book. But for every YUM investor there are many more Taco Bell, KFC, and Pizza Hut customers, and they are sharing their thoughts about those brands on social media constantly (to see an example for yourself, enter "Taco Bell" in the search field on Twitter now, and click the "Live" tab). A drop in social data sentiment and volume on Yum Brands offered a warning last June that was confirmed by the company's disappointing earnings release last October.

Tesla, however, would seem to be different from Yum Brands in the sense that the company's name also is its brand, so we're not sure how well the social data sorts out sentiment about the brand versus sentiment about the stock. For example, does the social data about "Tesla Model 3" capture the full purchase intent of social media users regarding the new model? Nevertheless, given LikeFolio's recent history on Tesla - putting out a bullish call near the bottom for the shares - perhaps it's worth paying attention to its bearish call as well.

Insurance For Tesla Investors Staying Long

If you've turned bearish too, you can follow their trade idea to bet against the stock. But the rest of this article is geared toward Tesla longs who want to stay long the stock, but limit their downside risk in the event the stock moves against them over the next several months. For those investors we'll present a couple of ways of hedging the stock below, one mainly for illustration purposes, as it's quite expensive, and another that may be more attractive to Tesla longs. If you'd like a refresher on hedging terms first, see the section titled "Refresher on Hedging Terms" in our REIT-hedging article from February ("Preparing for a drop in Realty Income").

Hedging TSLA With Optimal Puts

We're going to use Portfolio Armor's iOS app to find optimal puts and an optimal collar to hedge TSLA here, but you don't need the app to do this. You can find optimal puts and collars yourself by using the process we outlined in this article if you're willing to take the time and do the work. Whether you run the calculations yourself using the process in that article, or use the app, an additional piece of information you'll need to supply (along with the number of shares you're looking to hedge) when scanning for an optimal put is your "threshold," which is the maximum decline you are willing to risk. This will vary depending on your risk tolerance. For the purposes of the examples below, we've used a threshold of 17%. If you are more risk averse, you could use a smaller threshold (though not that much lower, in the case of Tesla now). And if you are less risk averse, you could use a larger one. All else equal, though, the higher the threshold, the cheaper it will be to hedge.

Here are the optimal puts, as of Tuesday's close, to hedge 200 shares of TSLA against a greater-than-17% drop by mid-September.

As you can see at the bottom of the screen capture above, the cost of this protection was $5,750, or 12.49% of position value. Given the high cost of hedging this way, we don't expect many Tesla longs to do so, but we are presenting this hedge for illustration purposes. Nevertheless, a couple of points about this cost:

  1. To be conservative, the cost was based on the ask price of the put - in practice, you can often buy puts for less (at some price between the bid and ask).
  2. The 17% threshold includes this cost: that is, in the worst case scenario, your TSLA position would be down 4.51%, not including the hedging cost.

Hedging TSLA With An Optimal Collar

When searching for an optimal collar, you'll need one more number in addition to your threshold, your "cap," which refers to the maximum upside you are willing to limit yourself to if the underlying security appreciates significantly. A logical starting point for the cap is your estimate of how the security will perform over the time period of the hedge. For example, if you're hedging over a several-month period, and you think a security won't appreciate more than 12% over that time frame, then it might make sense to use 12% as a cap - you don't think the security is going to do better than that anyway, so you're willing to sell someone else the right to call it away if it does better than that.

In previous articles on hedging, we've usually used potential return estimates from Portfolio Armor's website or potential returns derived from the median Wall Street price target for the stock. Neither works in the case of Tesla now. Tesla didn't pass the two screens to avoid bad investments our site runs before calculating potential returns, so our site didn't calculate a potential return for it. And the median Wall Street price target for the stock, $232.50, screen captured below via Yahoo Finance, implies a potential return of less than 1% over the time frame of our hedge.

So, instead, we used a cap of 8%, as this was the highest cap we could use with a 17% threshold without having a positive hedging cost.

As of Tuesday's close, this was the optimal collar to hedge 200 shares of TSLA against a greater-than-17% drop by mid-September while not capping an investor's upside at less than 8%.

As you can see in the first part of the optimal collar above, the cost of the put leg was $3,270, or 7.1% of position value. But if you look at the second part of the collar below, you'll see the income generated by selling the call leg was higher, $3,530, or 7.67% of position value.

So the net cost of this optimal collar was negative, meaning a Tesla shareholder would have received an amount equal to $260, or 0.56% of position value. One note on this hedge:

Similar to the situation with the optimal put, to be conservative, the cost of the optimal collar was calculated using the ask price of the puts and the bid price of the calls - in practice, an investor can often buy puts for less and sell calls for more (again, at some price between the bid and the ask), so, in reality, an investor would likely have collected more than $260 when opening this collar.

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.