8 August 2012 Update: I sold the Ford calls yesterday for a small gain. Still holding the Tesla puts.
Earlier this year, when Zynga was at $13 and change, I mentioned that Zynga’s high optimal hedging costs, as calculated by Portfolio Armor, might be a red flag for the stock. I didn’t know the stock would plummet as steeply as it has since…
…but the result is consistent with other examples of high optimal hedging costs presaging poor performance in stocks.
This week, I noticed another stock with high optimal hedging costs, Tesla Motors (TSLA). Ironically, what prompted me to look at how expensive it was to hedge was a tweet by the Tesla’s founder about guarding against downside risk:
— David Pinsen (@dpinsen) July 27, 2012
As the screenshot in that tweet shows, the cost of hedging against a greater-than-21% drop in Tesla over the next six months, as of Thursday, was over 19.5%. By Friday, Tesla was too expensive to hedge against a greater-than-21% drop, because the cost of that level of protection was itself greater than 21% of position value, so the smallest decline it could be hedged against was a greater-than-22% drop. The cost of that protection was expensive as well:
Out of curiosity, I also checked the cost of hedging one of Tesla’s competitors, Ford (F). As you can see below, it was much less expensive to hedge against the same percentage decline:
With all of that in mind, on Friday, I paired a long position in Ford with a short position in Tesla. Rather than buying and shorting the respective underlying shares, I bought calls on Ford and puts on Tesla. I bought ones expiring in March for both, to give the trade some time to develop.