To The Moon

In the automotive industry, $Tesla Motors(TSLA)$ has both become a trendsetter in electric vehicle adoption. The social media fandom for the company, its products as well as its founder Elon Musk has made it a meme stock. While it’s uncertain if this fandom is the reason for the company stock being so massively overvalued in terms of earnings and sales ratios, the fact remains that the stock is far, far ahead of its ratio-driven “fair value”. This is a widespread problem in the U.S. equity market – itself the most overvalued in the world.

Hedging for volatility is a challenge but not impossible. Given the high interest in Tesla’s stock in Europe, a number of issuers offer exchange-traded products (ETPs) that offer magnified exposure in either the downside or the upside of the stock’s trajectory. These products offer Tesla stockholders an interesting new solution to the question of value preservation. Let’s consider two such ETPs – a -3X Short Tesla ETP $-3X TSLA(TS3S.UK)$ and a +3X Long Tesla ETP $LEVSHARES 3X TESLA ETP(TSL3.UK)$ – to demonstrate a potential strategy.

A Rule-Based Hedging/Value Preservation Strategy

Let’s consider a sum of $10 million that needs to be invested in Tesla. The base case would be the outright purchase of 8,334 stocks as of the closing price on January 3rd of this year. The alternative would be an 80:20 split such that an initial amount of $2 million is reserved for the tactical purchase of ETPs in either leverage factor. This amount is not topped up or drawn down at any time; in the event of a sale of the ETPs, the proceeds are used to purchase the next batch of ETPs. The remaining $8 million is used to purchase 6,667 Tesla stocks on January 3rd.

To simplify the illustration, only one ETP factor is held at any time, i.e. either TS3S is held or TSL3.

Two trigger points are established: the “upper bound” trigger is calculated at 106% of the price at any time while the “lower bound” trigger is calculated at 94% of the price at any time.

Two strategies are considered:

Strategy 1 (or “Conservative Hedging”):

This strategy is built around two “4-day” rules. The first one is the factor decision of the day – “To Buy +3X or -3X?” – which sees if that day’s price has breached either trigger relative to the price seen 4 days ago. If the upper-bound is breached, the factor decision is “Buy +3X”. If the lower bound is breached, the decision is “Buy -3X”. In all other events, no decision is made.

The second rule is the holding decision, namely whether to continue holding a position in the ETP or not. Firstly, a counter is set up to count the number of days the present day’s price exceeds that of the previous day. Secondly, the holding decision is determined by this counter: over the course of 4 days including the present day and after the day of the last ETP purchase, if the counter is greater than 3, a short ETP position would be liquidated. Alternatively, if this counter is less than 2, a long ETP position would be liquidated. If neither, the ETP portfolio continues to be held.

Finally – after holding the position for at least 4 days after the day of ETP purchase – if there’s a change in factor decision (i.e. “Buy -3X” turns to “Buy +3X”) on the present day, the current ETP holding is liquidated and the corresponding ETP is purchased with the proceeds.

ETPs are tactical instruments that ideally shouldn’t be held for more than a day without active supervision. However, the relatively longer periods seen in this strategy helps limit transaction costs.

Strategy 2 (or “Active Hedging”)

This strategy forgoes the risk of higher transaction costs in favour of capitalizing on trends more rapidly.

The factor decision examines the present day’s price relative to the price seen 2 days ago. The holding decision is no longer constrained by the day of the last ETP purchase; from the very next day, the counter calculates to see the trend in day-on-day price increases over 3 days including the present. If the counter is greater than 2, a short ETP position would be liquidated. Alternatively, if this counter is less than 2, a long ETP position would be liquidated. If neither, the ETP portfolio continues to be held.

Strategy Choice Impact on Holdings

The more conservative “Strategy 1” predictably has a more harmonious transition between factors:

Note: Points indicate ETP price while the line itself describes the stock trajectory

January 7th : 5,000,000 TS3S bought at $0.4

February 3rd : TS3S holdings liquidated and 500,000 TSL3 bought at $4.8

February 11th : TSL3 holdings liquidated and 4,067,307 TS3S bought at $0.52

March 2nd : TS3S holdings liquidated and 402,893 TSL3 bought at $4.24

March 7th : TSL3 holdings liquidated and 2,387,514 TS3S bought at $0.54

March 18th : TS3S holdings liquidated and 191,219 TSL3 bought at $4.37

By comparison, the ETP holding pattern in “Strategy 2” is far more dynamic:

Note: Points indicate ETP price while the line itself describes the stock trajectory

January 5th : 5,882,352 TS3S bought at $0.34

January 11th : TS3S holdings liquidated and 227,459 TSL3 bought at $9.31

January 13th : TSL3 holdings liquidated and 4,968,183 TS3S bought at $0.38

January 31st : TS3S holdings liquidated and 373,280 TSL3 bought at $5.59

February 2nd : TSL3 holdings liquidated and 4,089,850 TS3S bought at $0.46

February 4th : TS3S holdings liquidated and 331,193 TSL3 bought at $5.31

February 7th : TSL3 holdings liquidated

February 8th : 3,881,890 TS3S bought at $0.43

February 9th : TS3S holdings liquidated and 299,154 TSL3 bought at $5.45

February 10th : TSL3 holdings liquidated and 3,303,989 TS3S bought at $0.45

February 15th : TS3S holdings liquidated and 261,512 TSL3 bought at $5.18

February 17th : TSL3 holdings liquidated and 2,448,197 TS3S bought at $0.47

February 25th : TS3S holdings liquidated and 415,319 TSL3 bought at $3.36

March 3rd : TSL3 holdings liquidated and 3,158,154 TS3S bought at $0.48

March 9th : TS3S holdings liquidated and 359,066 TSL3 bought at $3.87

March 11th : TSL3 holdings liquidated and 2,021,408 TS3S bought at $0.54

March 15th : TS3S holdings liquidated and 341,276 TSL3 bought at $0.52

Portfolio Choice Impact and Key Takeaways

Now, it bears noting that the portfolio values for both strategies are computed using the closing prices of the ETPs on any given day. During trading hours, these products’ prices change in tandem with that seen in the underlying Tesla stock and are computed by the broker. Investors must bear this fact in mind. Also, prices as well as risk factors differ across ETPs offered by different issuers, which investors must also consider. While the aforementioned strategies highlight several instances of a product being held for a number of days, one form of risk mitigation for cautious investors is to close out their position near the end of trading hours and reinitiate their position the next day.

Another item for investors’ consideration is that the choice made in holding ETPs only along the upside or the downside isn’t a rule. Given that there are a number of products with different leverage factors in the upside as well as the downside, many strategy styles could be developed by disciplined investors.

As of March 29th, the “Stock-Only” portfolio of 8,334 Tesla stocks, i.e. the benchmark to beat, is down to 91.6% of its value on January 3rd.

The more conservative “Strategy 1” doesn’t beat this benchmark and is down to 87.8% of its starting value. However, the active “Strategy 2” is down to only 99.1% of its starting value, thus handily beating both the benchmark and the competing strategy.

Note: All prtfolio values are based on closing prices and doesn't include any additional brokerage fees

While one takeaway that might be construed is that conservative strategies are less effective, this is by no means true in all cases. Tesla’s price trajectories have historically been rather histrionic with swings far more pronounced than those in many other stocks. ETP-based hedging strategies on other less-dramatic stocks could show relatively close performance between either strategy styles or even outperformance in the conservative style.

Using ETPs as a hedging strategy – as opposed to traditional instruments such as options and futures – might seem radical but they are certainly a viable option for investors who have access to them. ETPs also generally tend to have lower costs in general when compared to derivative premiums.

Given the enormous interest afforded to Tesla’s stock by investors, many ETP issuers are also working out investor-friendly measures to induce a more favourable consideration for ETP adoption. For instance, Leverage Shares has announced that the Arranger Fee on its “Short” Tesla ETPs has dropped to 0% as of the end of March. The fee has been stated to remain at 0% for at least 6 months until the end of September, after which a further extension on the “fee holiday” might be considered.

While there are a number of ETP issuers in the market that offer exposure to Tesla’s performance, none of them are currently offering a fee holiday. Fee expense is another factor that investors can consider while plotting the costs of value preservation. Typically, ETP fees typically aren’t a significant factor in most cases but the fee savings is money available for the taking while implementing a hedging strategy for a stock as important and volatile as Tesla. More innovations in costs savings by different ETP issuers might be expected in the near future.