In the automotive industry Tesla 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 (TS3S) and a +3X Long Tesla ETP (TSLS) – to demonstrate a potential strategy. While the previous article had discussed the value of using TS3S to prop up portfolio values in across a relatively short duration, this article will demonstrate the utility of the approach of using ETPs in either direction in overall portfolio management.
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:
