Seeking Alpha readers well remember Montana Skeptic, who wrote meticulously researched pieces here about Tesla (TSLA). Although decidedly bearish on Tesla, he also believed Tesla to be such a risky short that he chose for himself an options-only stance to limit downside.
We suspect volatility colored Montana’s view. Tesla is volatile, volatility equals risk, ergo Tesla is a dangerous short. Utterly logical.
But, if you really believe Tesla is hugely overvalued and its share price will some day fall to earth, then why not embrace volatility and use every lever available to potentially maximize profit and minimize risk?
Can You Handle Some Cognitive Dissonance?
So, what does this trade that embraces volatility look like? It consists (for Tesla bears) of buying call options in conjunction with shorting shares.
Using call options to supplement short positions requires a certain mentality. You have to be capable of some cognitive dissonance and thereby allow yourself to use a bullish position to fortify your bearish overall investment.
And, as we detail below, it also involves discipline. There are two rules you absolutely must follow for this strategy to succeed, and both require working against your natural instincts.
But before we get into the details of the trade, let’s discuss why put options alone are less than optimal for someone taking a bearish view of Tesla.
There are obvious drawbacks to using only options to create a short position. The biggest, in our view, arises from delta. Overly simplified, delta is the ratio behind the expected move in the option vs. the underlying shares. At a delta of .53, for every one-dollar move in the underlying share price, an option (put or call) will move by 53 cents.
Delta is dynamic. It moves higher or lower the more the option is in or out of the money. A deep in-the-money option will eventually have a delta of 1.0 and be perfectly correlated with the stock. The opposite also is true: The deeper out of the money an option becomes, the more delta moves toward zero. Because of delta, the profit potential in an option vs. shares is simply not as great and never will be.
As of this writing, Tesla Nov 345 calls trade at a .53 delta, and the Nov 345 puts .46. The December strikes aren’t much different. But the Nov 295 calls trade at a .91 delta as do the Nov 395 puts. You see how much the stock has to move in order to capture full, dollar-for-dollar coverage via options.
(Delta – here indicated under “DM” columns – approaches 1 as options become deeper in the money, and approaches zero as options become further out of the money.)
And Now, The Rules You Must Live By
Using call options in conjunction with shorting shares requires that you be willing to live by two rules, with no waivers or exceptions allowed.
Rule #1: always be happy to lose money on a call.
Yes, you must embrace the losses on your call options. But then, why not just take Montana’s advice and use puts? Isn’t losing on the call the same as spending premium for a put and waiting for the delta payoff? Yes and no. Yes, because losing on the call is a cost, no because of how delta impacts profitability.
Here’s an example from our recent trading. Early in Q2 2017, when Tesla shares had fallen temporarily into the $295-$300 range, we purchased June 285 calls as part of our normal, dispassionate rule-driven options roll in a notional amount that mostly covered our short exposure.
We had no idea Tesla would rally as much as it did post purchase, but most importantly, we didn’t care. Why not? Because of Rule #1, we had a hedge in place that enabled us to sleep peacefully as we waited (and wait) for Tesla to complete its Kabuki dance. While gains on our calls never fully covered losses on the short (delta), they cut the loss substantially enough that our Tesla short in Q2 2017 wasn’t even in our top 20 loss positions.
You know the expression “the market can stay elevated longer than you can stay solvent?” Rule #1 mostly keeps one solvent. But it also provides other material benefits. Calls cut down the notional value of one’s short and enable an investor to increase both position size and basis as the stock moves higher.
Because no one’s timing is ever perfect, we have a risk control rule that generally requires us to initiate any sizeable position at only 50% of what we actually want. Rule #1 allows us the freedom to make our position bigger at higher prices without materially impacting the portfolio’s risk profile. So, as Tesla was rallying, we shorted more and improved the basis of the position as we made it bigger.
Rule #1 also protects against borrow risks. When we began shorting Tesla in 2016, borrow costs were low (and have moved higher and lower since). But if Tesla cracks and short interest spikes, then borrowing the stock could become expensive, if not impossible. Instead of reducing short shares and risk not getting borrows later, buying calls enables us to maintain our short and add to it when borrow costs actually are dropping.
Rule #2: resist the temptation to lift the coverage.
This rule is inviolate. It exists to protect you against the greatest investing danger out there: Yourself.
Yes, the moment will come when you feel that lifting the call protection will maximize your profits. Do not succumb. One of my partners, in our weekly portfolio management meetings, is fond of reciting the old maxim of not letting the perfect be the enemy of the good. So it is with shorting and options.
Here’s how these rules recently worked together for us. During most of the fourth quarter of 2017, Model 3 production concerns knocked Tesla shares down and we lost money on our calls. But because we had earlier used Rule #1 to increase our stake at higher entry points, we still generated a nice profit on the position.
In early December 2017, we bought January 335 calls at $13.50. We rode those up to $19.00 and then promptly watched them trade as low as $2.50.
Yes, we left money on the table by not trading out. But two weeks later the shares were back over $340 on no news, and our long calls cut our loss on the short in half, and those calls will cut the loss even more if the stock continues to rally.
Never forget: Rule #2 is the hedge against nuttiness and itchy trigger fingers. It’s the hedge against your susceptibility to temptation.
Take Emotion Out of Your Trading
You already can see a huge benefit to using call options in conjunction with shorting shares, and with adhering close to the two rules above: The strategy takes emotion out of the equation.
Elon Musk goes on a midnight tweetstorm, promising new Service Centers in Peru and Nepal, and the share price suddenly spikes? Rather than gnashing your teeth, you laugh at him.
Adam Jonas comes out with another note valuing the non-existent Tesla mobility at $100 per share, and increasing his price target to $400? You’re amused, not angry.
Explaining her price target of $4,000, Cathie Wood goes on CNBC to tout an imaginary product in an imaginary market with imaginary margins (though her imagination fails her when it comes to imagining competitors)? You shake your head sadly at the insanity of it all, but have no worries about your portfolio positioning.
Tesla’s Rapid Shareholder Turn
While the average S&P 500 stock turns its shareholder base over every 200 days or so, Tesla (which is not in the S&P 500, but with a market cap far larger than most S&P members) does it in about 20. That’s unprecedented in public markets and it means the stock is dominated by day trading technicians. This makes for an extremely volatile brew.
Indeed, at points early on in 2018, Tesla would occasionally trade up 18 to 20 points on a day with no material headlines. Montana Skeptic was not wrong – shorting stocks as volatile as Tesla will test anyone’s constitution.
So why bother?
Because we agree with Jim Chanos and Mark Spiegel. Tesla could be one of those once-in-a-lifetime shorts. When we typically short, we are looking for a move down between 10 and 20 percent.
Not so with Tesla, our largest short position. We expect to wake up one day with Tesla stock down $30, headed to down $150, and who knows from there.
Investing demands patience, whether you be long or short. But since shorting adds leverage to portfolios and therefore creates larger opportunity costs if one is wrong, the benefits of considering more structured portfolios when shorting are substantial and worth it. And if investing is a test of patience, it's also an inexact science. One’s timing is never perfect and every investor will make mistakes.
The key is insuring those mistakes not be fatal. One of the most important reasons to use options in conjunction with shares, especially when you are on the short side, is to increase your margin for error.
Are there risks associated with this approach? Yes. Opportunity cost. If you are right in your short thesis, and the stock declines, you will make less money pairing a short with call options than if you just shorted the shares. But I hope we have outlined why giving a little back to the house can be beneficial.
It can take years for a short thesis to play out. A put-only short position will be costly as those puts could expire worthless and need to be long dated or the investor will have to be nimble and disciplined enough to roll the puts out constantly lest the investor risk missing the big move.
On the other hand, an options portfolio tied to a short position lessens risk by reducing the volatility of the overall position and enabling the short investor to wait, calmly, for the big break, while remaining fully invested.
At some point, Tesla will either work as a short or not. In the meantime, Musk can tweet all he wants, and the day traders can push shares up. Our options hedge allows us to be indifferent.
Disclosure: I am/we are short TSLA.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.