Tesla (TSLA - Free Report) is the most heavily shorted stock in the market by a wide margin. With somewhere in the neighborhood of $11 billion in short interest, it easily tops the second most shorted company in the U.S., Apple (AAPL - Free Report) , which currently has about $9B of shorts. When measured in terms of market capitalization, however, Tesla short interest is even more significant. Apple’s market cap is $930B, compared to Tesla’s $50B. That means that more than 20% of Tesla’s market cap (and 30% of shares actually available to borrow and sell) is short interest.
Tesla has been heavily shorted for most of its tenure as a public company and for the most part, it has been a painful trade as the shares marched from the high teens in 2010 to an all-time high of $389 in 2017.
The shorts took in…well…in the shorts during the first big run-ups to $180 in 2013, and then to $280 in 2014, and finally to $389 last year. Though it’s impossible to exactly quantify the effect, short covering is believed to have been a major catalyst in each of these bull runs.
Emboldened by the recent sell-off in share value, significant uncertainty surrounding Tesla’s production issues with the mass-market Model 3 and its ability to turn a profit, the shorts have piled in heavily again, betting that the shares will fall and they’ll be there to reap the rewards.
Tesla CEO Elon Musk has directly targeted short sellers, both by personally purchasing additional shares (though his recent purchase of $10M in stock is largely symbolic in the face of $11B in short interest) and also with a bit of jawboning on Twitter in which he bragged, “Oh and Uh short burn of the century comin (sic) soon.”
A quick aside: The short burn of this century so far was the incredible squeeze in shares of Volkswagen A.G in 2008, when Porsche announced that they owned 43% of outstanding shares and held options to acquire 33% more. Combined with the government ownership of 20%, that meant less than 6% of shares were available to cover short positions and the stock rallied 500% in three days, eviscerating the shorts who were left scrambling to cover. Unless Tesla does something really spectacular – beyond what even the biggest Tesla bulls expect - 500% inside of a week is likely to stand for a while as the undisputed King of short squeezes.
Short Selling, a Primer
To understand how a short squeeze, let’s quickly examine the mechanics of the trade.
In a typical short sale, a trader who wants to bet on a decline in a stock’s price will borrow shares from a broker who is holding long shares for a customer and then sell those shares to the market. To close the trade, the trader buys the shares back in the market and returns them to the brokerage customer. If the stock has declined and the repurchase price is lower than the initial sale, the trader pockets the difference. Additionally, while the short trade is on, the trader earns interest on the cash balance resulting from the sale.
For most large-cap stocks, there are so many shares available that traders can sell short freely - as there are always plenty of shares to borrow. The short seller can still lose money if the stock rallies instead of declining, but the trader is basically free to enter and exit the trade at will.
In smaller stocks though, especially those with a significant percentage of short interest, when good news is announced and investors buy shares to increase long exposure in the stock, short sellers who want to cut their losses and head for the exits find that all the shorts are heading there at the same time. The scarcity of shares available to buy is so small that the short covering drives up the price even further, amplifying losses for those who exit late. This is a basic “Short Squeeze.”
Regulation enacted by the SEC in 2008 to end “naked” short selling - or selling shares that have not actually been borrowed ahead of time - exacerbates the short squeeze effect.
What Does This Have to Do With Options?
In addition to traditional short selling, many traders have taken net short positions in Tesla using options. Typically, buying puts is a more popular way to make a short bet in a stock than selling calls due to the aspect of limited risk and unlimited return, though some shorts may sell calls as well, sometimes to finance the long puts.
You’ll recall from the Know Your Options piece on Implied Volatility (read it here>>), that options market makers generally hedge the delta of their option position by buying or selling the underlying stock to become delta-neutral – or indifferent to small changes in the price of the stock. Also recall that when the stock moves a significant amount, those market makers need to adjust their hedge trades as the option deltas change so that they are delta neutral at the new stock price.
When a trader initiates a short position by buying puts, the market maker that sold them typically sells stock to make the total delta of his position close to zero. Then, as the stock moves up or down, the delta of the puts changes and the market maker buys or sells shares to re-adjust the position delta.
Let’s examine what happens when a heavily shorted stock begins to rally.
Let’s say a large number of shorts have purchased at-the-money puts in Tesla. The market makers (who sold the puts) sell shares short in the market as a hedge, at a ratio of one share for every 2 options - because at the money options have a delta of 0.50 (or 50 Delta). So if the short trader purchased 1,000 puts, the market makers would collectively sell 50,000 shares as a hedge.
If the stock were to rise, the delta of the puts would fall, as they would no longer be at the money. The farther out of the money an option is, the lower the delta. If the delta of those puts fell to 0.40, the market makers would have 10,000 shares to buy to adjust their position delta to neutral. If the stock continued to rally and the put delta was now 0.30, they’d have 10,000 more to buy, and so on until the delta of the options was close to zero.
This option re-hedging can have a significant effect during a short squeeze because even if the shorts who have sold the actual shares are brave enough (or well capitalized enough) to take the paper loss and avoid buying shares in a rising market, if there are a significant amount of puts outstanding, the sellers of the puts are likely to be buying shares no matter what, piling on during the run-up in the stock.
Examining the data on Tesla
So if a stock with large ownership of put options is especially vulnerable to short squeezes because of the additional buying volumes as traders adjust hedges, what does open interest in options tell us about Tesla? Specifically, let’s examine how much of the option open interest is puts and how much is calls.
The Chicago Board Options Exchange (CBOE - Free Report) has published data on the put/call ratio across options on all stocks for every single trading day back to 2006. It’s too large a set of data to effectively reproduce here, but it can be found on the CBOE website here for anyone who’s interested.
Over 2904 trading days, the average put/call ratio is 0.65, meaning about 3 calls trade for every 2 puts. That’s across the entire universe of equity options. This stands to reason as the markets have generally risen during that period and most investors have a bullish bias. (There are a few brief periods during the financial crisis in 2008 when puts outnumbered calls.)
As of May 15th, the put/call ratio in Tesla options for outstanding options with 120 days to expiration (through the next earnings cycle) is a whopping 2.4! That is, there have been nearly 5 puts purchased for every 2 calls. Additionally, the average implied volatility for puts is historically high at 52%, suggesting that many more options have been purchased by the investing public than sold.
Additionally, because the shares are scarce and sometimes difficult to locate before being sold, traders with a short position do not earn interest on short position. Rather, they actually pay to be short to compensate the brokerage firm for finding shares to sell. The current rates are about 2.3% annually for professional market makers and between 3% and 6% annually for retail investors. The normal "short rebate" is negative, so it's actually a short fee.
The large numbers of puts market makers are short is likely to accelerate any rapid upward movement in the stock as re-hedging activity requires the purchase of large numbers of shares.
When combined with scarcity of common shares available for purchase to cover shorts and a negative short rebate, options open interest is likely to add to any short squeeze if it materializes.
Of course, if Tesla fails to deliver on the Model 3 or if there’s a slew of other negative news, the stock could decline and all this will be a moot point, but the data suggests that if the stock does start to rally sharply, it’s going to have a strong tailwind behind it.
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