Why These Tesla Investors Got Burned

Tesla's Model S sedan. Photo credit: Tesla Motors.

Tesla Motors is a stock that many people -- including quite a few professional investors -- love to hate.

Whether it's because of the politics of electric cars, because billionaire CEO Elon Musk's brash and snarky manner, or simply because its valuation sparks comparisons to the wilder stocks of the old dot-com bubble era, plenty of folks either don't want Tesla to succeed, or just honestly don't believe that it can.


Many of those folks have put their money where their ideas are, by investing in a short position in Tesla's stock.

And at least this week, a lot of those folks got burned in a big way. Here's what happened.

How a short position lets investors bet against a stock
First, let's explain. When investors take a short position, what they're doing is borrowing someone else's stock and selling it, betting that they can buy it back later (to repay the loan) at a lower price.

If investors think that a company's stock is overpriced, they can ask their broker to set up a short position that will give them a profit when the stock price falls. The farther it falls, the bigger the profit.

But whether the stock price goes down or up, the investor still has to pay back the loan. And the investor has to pay interest on the stock he or she borrowed in the meantime, which typically isn't cheap.

If the stock skyrockets, the investor can lose a lot of money -- far more than the original investment. And the longer that person waits to close their position, the more interest he or she has to pay.

In other words, selling a stock short is a risky move. That's why smart investors save it for cases when they think a stock is wildly overvalued, where its price is so high that it doesn't seem to make sense.

Where it seems like a sure thing to crash, in other words.

Now let's look at Tesla.

From this perspective, Tesla looked like a classic short candidate
There's a case to be made for Tesla, but it's the case against Tesla that we're interested in right now. It's easy to sum up: Here's a company that has been around for a decade but hadn't had a quarterly profit ever until this past week. It's selling a new kind of product -- electric luxury cars -- that competes against massive global companies, and it's unclear that enough consumers want that new kind of product to make the business worthwhile.

I mean, would you pick some unproven California startup to go up against the likes of Ford or Toyota ? (Yes, Toyota is actually a Tesla investor, but bear with me here for a minute.)

Whether you would or not, a lot of people have chosen to invest in Tesla, and that meant that Tesla's stock price went way up -- even though the company hadn't yet earned any money.

That was an irresistible situation for many investors, who opened up big short positions on Tesla. And when I say "many investors," I mean many: As of a few days ago, about 40% of the Tesla shares on the open market had been sold short, according to The Wall Street Journal.

That's huge. And it set the stage for what happened next.

A textbook "short squeeze" was like rocket fuel for the stock
That big percentage, what we call a high short interest in Tesla, meant that the stock was primed for a short squeeze. That's what happens when there's a big positive development on a stock with a high short interest that drives the price up.

When there's a high short interest on that stock, the price can go up very very quickly. That's because all those short investors are rushing to buy the stock to cover -- close out -- their investments before the stock gets even more expensive.

In other words, those short investors get squeezed.

That looks like exactly what happened. Tesla's stock closed at $55.79 on Wednesday. After that, two things happened:

  • Tesla announced a profit. After the market closed on Wednesday, Tesla announced its first-ever quarterly profit. It was small -- only $15 million or $0.12 a share excluding some special items -- but Wall Street had expected just $0.04 a share. The stock went up big in after-hours trading.
  • Consumer Reports threw fuel on the fire. The next morning, Consumer Reports announced that Tesla's Model S sedan, shown above, had scored 99 out of 100 in its testing. That's equal to the best cars the magazine has ever tested. That's a big, big seal of approval for a start-up carmaker, and it added even more fuel to the rocket driving Tesla's stock price higher.

So even though its price was already high,Tesla's stock soared on the one-two hit of great news. That probably led many shorts to rush to close their positions, and that in turn drove the stock up even higher: Tesla closed at $69.40 on Thursday. And it kept going: Tesla stock closed at $76.70 on Friday. It might go even higher next week.

But won't it eventually come down?

Tesla could return to Earth ... eventually
Sure, it might. While Tesla has done a very impressive job of executing on its business plan, there's still a long way to go before it will make enough money to justify anything like its sky-high stock price. And it may never get that far, for two big reasons.

First, electric cars are still a niche market, and that might not change. Tesla might be able to sell enough cars every year to make a profit, but it might be a small profit that only justifies a share price of $10, not $70.

Second, if electric cars do start to get popular, there are massive competitors waiting to step in: all of the world's big automakers. They all have research resources and economies of scale that absolutely dwarf anything Tesla will be able to muster. How Tesla will survive and thrive when it's competing against the big automakers is an open question, and a daunting one.

All of that could drive the stock down in time. Probably will, say some analysts.

But there's an old saying among stock traders: The market can stay irrational longer than you can stay solvent. Short sellers who are making big interest payments may not be able to afford to hang on until Tesla's price falls -- if it ever does.

Long story short (so to speak), they're getting burned. If you own Tesla stock, enjoy the ride.

Leave short selling to the pros. The best investing approach is to choose great companies and stick with them for the long term. The Motley Fool's free report "3 Stocks That Will Help You Retire Rich" names stocks that could help you build long-term wealth and retire well, along with some winning wealth-building strategies that every investor should be aware of. Click here now to keep reading.

The article Why These Tesla Investors Got Burned originally appeared on Fool.com.

Fool contributor John Rosevear owns shares of Ford. Follow him on Twitter at @jrosevear. The Motley Fool recommends and owns shares of Ford and Tesla Motors . Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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