Elon Musk Transfers Money From Cash To Checking
That's how one wag described Elon Musk's bid for his electric car company Tesla (NASDAQ:TSLA) to buy his solar energy company SolarCity (SCTY). Jim Chanos called it "corporate governance at its worst."
Seeking Alpha contributors, on the whole, offered similarly negative assessments, as Seeking Alpha editor Rocco Pendola noted ("Tesla-Solar City: Elon Musk, The Crazy, Misfit Rebel Who Makes Trouble And Fits Round Pegs Into Square Holes"). Tesla longs who were hedged can read the articles Rocco collected, confident that their downside is strictly limited.
Softening The Blow For Tesla Longs
Back in May, we looked at ways of hedging Tesla ("Tesla Model 3: Cannibalizing Sales?"). The stock was prohibitively expensive to hedge with optimal puts, so we tried to hedge it with an optimal collar. Using collars means you have to decide where to cap your potential upside. We discussed a couple of issues we had in coming up with a cap for Tesla:
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. 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.
As of May 20th, Tesla still didn't pass our site's two screens, so the Portfolio Armor website didn't estimate a potential return for it. But Wall Street analysts have raised their price targets on the stock as the screen capture from Yahoo below shows.
That median 12-month price target implies a potential return of about 13% between now and mid-December, so we used that as the cap in the updated hedge below.
Let's take a look at that optimal collar and how it reacted after the Tesla-SolarCity news. Then we'll consider courses of action for hedged Tesla longs.
May 20th's Optimal Collar Hedge
As of May 20th's close, this was the optimal collar to hedge 200 shares of TSLA against a greater than 17% drop by mid-December, while not capping an investor's upside at less than 13% by the end of that time period (screen captures via the Portfolio Armor iOS app).
As you can see at the bottom of the screen capture above, the net cost here was $20.
How The May 20th Collar Responded To Tesla's Drop
Here's an updated quote on the put leg as of Wednesday:
And here is an updated quote on the call leg:
How That Hedge Ameliorated Tesla's Slide
TSLA closed at $220.28 on Friday, May 20th. A shareholder who owned 200 shares of it and hedged with the collar above then had $44,056 in TSLA stock plus $2,950 in puts, and if he wanted to buy-to-close his short call leg, he would have needed to pay $2,930 to do that. So, his net position value on May 20th was ($44,056 + $2,950) - $2,930 = $44,076.
TSLA closed at $196.66 on Wednesday, June 22nd, down 10.7% from its closing price on May 20th. The investor's shares were worth $39,332 as of 6/22, his put options were worth $4,230 and if he wanted to close out the short call leg of his collar, it would have cost him $1,380. So: ($39,332+ $4,230) - $1,380 = $42,180. $42,180 represents a 4.3% drop from $44,076.*
So, although TSLA had dropped by 10.7% at the time of the calculations above, and the investor's hedge was designed to limit him to a loss of no more than 17%, he was actually down about 4.3% on his combined net 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 Tesla investor hedged with this collar could have exited with a 4.3% loss position Wednesday (instead of a 10.7% one), 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, after eliminating his upside cap, he could sell his puts and use the proceeds to buy more stock.
When backtesting the hedged portfolio method, we tested variations of the first two of those four scenarios. We looked at whether, on average, hedged portfolio performance was better if those losing positions were exited 3 months into the duration of the portfolio, or held for 6 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. But one difference there is the securities we tested those variations on had all passed our two screens, whereas Tesla hadn't.
If you're hedged and long Tesla, you have time to read all of the articles Rocco linked to and carefully weigh your decision. But you may want to hold onto your puts, just in case Musk decides to have Tesla buy SpaceX.
*If you want to be picayune about it, you'll note the last prices of the options occurred 9 minutes and 10 minutes, respectively, before the last price of the stock. For simplicity's sake, we've used the last prices of all three here, but if you sliced this a different way - say, using the intra-day price of the stock at the time the options traded - the results would have been similar.
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.