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:
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:
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 computing 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 (as we had mentioned in an earlier article 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.
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 European investors. 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.
Sandeep joined Leverage Shares in September 2020. He leads research on existing and new product lines, asset classes, and strategies, with special emphasis on analysis of recent events and developments.
Sandeep has longstanding experience with financial markets. Starting with a Chicago-based hedge fund as a financial engineer, his career has spanned a variety of domains and organizations over a course of 8 years – from Barclays Capital’s Prime Services Division to (most recently) Nasdaq’s Index Research Team.
Sandeep holds an M.S. in Finance as well as an MBA from Illinois Institute of Technology Chicago.
Violeta joined Leverage Shares in September 2022. She is responsible for conducting technical analysis, macro and equity research, providing valuable insights to help shape investment strategies for clients.
Prior to joining LS, Violeta worked at several high-profile investment firms in Australia, such as Tollhurst and Morgans Financial where she spent the past 12 years of her career.
Violeta is a certified market technician from the Australian Technical Analysts Association and holds a Post Graduate Diploma of Applied Finance and Investment from Kaplan Professional (FINSIA), Australia, where she was a lecturer for a number of years.
Julian joined Leverage Shares in 2018 as part of the company’s premier expansion in Eastern Europe. He is responsible for web content and raising brand awareness.
Julian has been academically involved with economics, psychology, sociology, European politics & linguistics. He has experience in business development and marketing through business ventures of his own.
For Julian, Leverage Shares is an innovator in the field of finance & fintech, and he always looks forward with excitement to share the next big news with investors in the UK & Europe.
Oktay joined Leverage Shares in late 2019. He is responsible for driving business growth by maintaining key relationships and developing sales activity across English-speaking markets.
He joined LS from UniCredit, where he was a corporate relationship manager for multinationals. His previous experience is in corporate finance and fund administration at firms like IBM Bulgaria and DeGiro / FundShare.
Oktay holds a BA in Finance & Accounting and a post-graduate certificate in Entrepreneurship from Babson College. He is also a CFA charterholder.
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