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Seeking to explain the lack of observable short covering in
shares of Tesla since the start of December
Convertible bond arbitrage may constitute half of reported
short interest
Suggests smaller losses for directional shorts than exchange SI
would imply
Hedging of call options sold to Tesla may be contributing to
price move
After Tesla reported an unexpected quarterly profit on October
23rd, its share price was launched into an upward trajectory.
Between October 23rd and the end of November the share price
increased by 30%, while the short interest declined by an estimated
23%. The reaction from shorts surprised no one, as Tesla was
already one of the most shorted US equities in terms of dollar
value and percentage of shares outstanding, leaving relatively few
short sellers to get involved as shares were substantially above
the 2019 low observed in May. What happened next, however, has left
some scratching their heads at the resiliency of short sellers in
the face of a relentless rally which took shares up to $780, or
+136% since the start of December. There may be more to the story
than meets the eye, if that eye is trained only on the stated short
interest.
The short interest in Tesla shares was 24.9m shares for January
15th settlement, published by NASDAQ, per FINRA regulated broker
dealer disclosures. This suggests that short positions in the
electric carmaker only decreased by 1.3m over the first two weeks
of 2020 (-5%), while the share price rallied by 24%. Similarly, in
December the share price increased by 27%, while the short interest
declined by just 8%. Overall that means a 13% reduction in shares
short during that 1.5-month span, while the share price increased
by 57%. This certainly implies some pain for directional short
sellers, however it's worth considering another group which likely
increased their short position in share terms during that time: the
owners of Tesla's convertible bonds.
Since the start of December, the price of the Tesla 1.25% 2021
convertible bond increased by 96%, through February 3rd, compared
with the 136% increase in the price of the Tesla common equity. For
a convertible arbitrageur, there is be a tendency to increase short
positions in the common shares up to the point where the delta to
the share price reaches 1, meaning that the change in price for the
convertible bond equals the change in price for the equity. That
appears to be happening now. On February 3rd, the common share
price increased by 19.9%, while the 1.25% 2021 convertible
increased in by price by 17% (the other two Tesla convertible bonds
also saw price increases greater than 17% on the 3rd). As of
10:30am on February 4th, the price of the 1.25% 2021 convert was
+18% day over day, per IHS Markit Evaluated Bond Pricing dataset,
while the Tesla equity was up "only" 16%.
The implication is that convertible arbitrageurs have likely
been increasing their short positions over the last three months
and may have only recently completed the process of hedging the
embedded options in this last push higher in share price. That may
also mean that directional shorts have reduced their exposure by a
much larger amount than suggested by looking at the total short
interest. If the owners of the convertible bonds have fully hedged
the shares into which their bonds could be converted, that would
imply 12.7m shares short, just over half the short interest
reported for January 15th. Given the 50% increase in share price
since January 15th it seems reasonable to assume some amount of
directional short covering, however that analysis is muddied for
reasons we'll discuss after a brief discursion.
One factor which may have influenced the share price over the
recent rally is short exposure to call options. Historically, when
Tesla sold convertible bonds, they also purchased calls at the
conversion price and simultaneously sold warrants with higher
strike prices. The stated purpose for these transactions was to
reduce the impact of dilution should the share price exceed the
conversion price at maturity, as Tesla could effectively buy back
shares in the market with the proceeds of the profitable call
option that they purchased. That antidilutive measure would only
hold up to the strike price of the warrants that Tesla sold to
offset the cost of the call option. As noted in the prospectus for
the 1.25% 2021 convertibles: "However, the warrant transactions
could separately have a dilutive effect to the extent that the
market price per share of Common Stock exceeds the applicable
strike price of the warrants on the applicable expiration dates."
The strike price for those warrants is $560 per share. In
considering all potential forces driving the Tesla share price
higher, hedging activity related to the calls Tesla purchased, and
potentially Tesla hedging the warrants, which it in turn sold, may
be playing a role.
Apart from increased directional long exposure, and potential
hedging of short call exposure, the covering of directional short
positions may well have contributed to the increase in price since
the January 15th short interest publication. Efforts to track short
interest in real time, using shares borrowed in the securities
finance market as a proxy, have been frustrated over the last 12
months. Broker-dealers have needed to borrow fewer shares to meet
the demand from short sellers, which implies a greater ability to
source shares from positions in their custody. That may reflect, in
part, an increased long hedge on the part of the broker dealers who
sold Tesla the call options related to the convertible bond sales,
which are now deep in the money. From the start of 2015 to the end
of 2018 the average difference between the shares on loan reported
to IHS Markit and the short interest reported by NASDAQ was 1.7m
shares. Since the start of 2019 the difference has averaged 6.2m
shares. Zooming in on the period following Q3 earnings, the implied
internalization of borrowed shares increased from 5.7m shares on
October 15th to 9.8m shares on January 15th (peaking at 13m shares
on Dec 13). The 1.7m increase in borrowed shares YTD likely
reflects a diminished ability to internalize the borrow, however
convertible arbitrageurs value stability of borrow rather highly,
so increase in borrows could also reflect the increased composition
of arbs among open short positions.
Conclusion:
This article aims to provide some explanation as to why the
short interest hasn't declined as much as one might expect as the
share price continues to rocket higher. That question of course
begs the follow up: If this isn't short covering, what is it? The
explanations offered here are: Increasing convertible arbitrage
shorts which offset declining directional positions, long buying to
hedge short call positions and, in a bit of a cop out, the
possibility that directional short positions are declining to a
greater extent than can be observed in real time, which only
applies to period starting Jan 16. The NASDAQ 100, which counts
Tesla as a constituent, has increased in price by just over 30%
since the 2019 low for Tesla, which may also be contributing to the
buoyancy of Tesla shares. One final answer, which may be the most
significant going forward: Increased long positions on the part of
investors excited about the dawn of the electric car age are likely
playing a role, as they have over the nearly ten years since the
company went public.
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