I don’t think any stock quite sums up the mania of 2020 quite like Nikola (NKLA). With no sales, no plan to reach sales, and a small market, it reached a market cap of over $30B. Soon after, the company was accused of fraud, at which points the stock took a ~45% slide, before almost doubling back up by late last week.
The day I saw the stock pop after the SPAC closed, I thought about shorting. But how does that old saying go? “the market can stay irrational longer than you can stay solvent“? I don’t think things have really changed in that regard. It would be great to be able to put shorts on a whole host of these frauds (GSX, NNOX, etc.), but there isn’t a whole lot stopping you from immediate sharp loses as they double and triple.
Or is there? I believe there are three short term tactical catalysts that could give investors a way to short NKLA for the short term:
1. The deadline to announce the GM partnership is December 4th
2. The lock-up period for pre-SPAC investors expires at the end of the month
3. The current open interest on vanilla option contracts could reflexively impact the market in an asymmetrically negative manner as other catalysts unfold.
Each of these factors will impact NKLA over the coming month, and could be the impact I would (this is not investment advice) to pull the trigger on a short position.
1. The deadline to announce the GM partnership is December 3rd
The deadline for NKLA to finalize a deal with GM to produce their EV pick up truck is December 3rd, and it isn’t looking likely. Shares drop >15% on the news that the CEO gave a wishy-washy interview about the agreement, so imagine how much it could drop as retail investors find out the whole deal has fallen through.
And just thinking through what has happened since this merger agreement went into effect– the company has received significant negative publicity, the Founder has accused of fraud and rape (twice), and the company has been subpoenaed by the SEC. Sure, GM basically gets a free call option on $1.4B on stock, but it is at the risk of their own reputation. I believe (i) there is significant risk this deal falls through, and will have a materials negative impact on the share price, and (ii) if the deal goes through at some time after December 3rd, there will still be a materials negative impact on the share price to the “lack of news” as the date comes and goes.
2. The lock-up period for pre-SPAC investors expires November 30th
Back in July, NKLA filed an S-1 with the SEC. On page F-80, the company outlines when “Original Holders” (defined as “Founder Shares” and “Private Placement Units”) can begin selling there shares. Full text copied below:
The securities held by the Original Holders will be locked-up for one year following the Closing, subject to earlier release if (i) the reported last sale price of the Company’s common stock equals or exceeds $12.00 per share (as adjusted for stock splits, stock dividends, reorganizations, recapitalizations and the like) for any 20 trading days within any 30-trading day period commencing at least 150 days after the Closing or (ii) if the Company consummates a liquidation, merger, stock exchange or other similar transaction after the Closing which results in all of the Company’s stockholders having the right to exchange their shares of common stock for cash, securities or other property.
Closing was on June 3rd; 150 days from that was Oct. 31st; the consecutive 20 trading days expires on November 30th; which means December 1st is the first day many of these shares can begin to be sold in the public market.
The S-1 then goes on to discuss the lock-up period for “New Holders” (defined as “certain stockholders of Legacy Nikola”). Full text copied below:
The securities held by the New Holders, other than certain entities controlled by Trevor Milton, the current Chief Executive Officer of Nikola, will be locked-up for 180 days after the Closing. The securities held by certain entities controlled by Trevor Milton will be locked up for one year following the Closing, except that they would be permitted to sell or otherwise transfer an aggregate of $70.0 million shares of the Company’s common stock commencing 180 days after the Closing.
Closing was on June 3rd, 180 days from closing is November 30th, which means these shares can also be traded live on December 1st. In total, this equates to ~166M shares, equal to approximately 44% of total shares outstanding (10-Q, page 60). The average volume of over the past 21 trading days has been ~17M, but it’s important to note that the range of volume is large– over month has been as low as 5.4M and as high as 60M (as high as 139M since late august).
This is a significant number, and will be sure to have a material negative impact. The recent stock price could be somewhat of a mitigators here– people shorting in preparation who plan to buy back as the 166M unfold, but on ~60M shares traded on that drop, which would mean if all sellers were shorting in preparation, there is still 10x the average daily volume waiting to be sold next week.
If I had more time and/or resources, I would love to dive deeper into the order book depth, to see how much of an impact this could really have. But unfortunately, I have neither, and so the final step of math will be incomplete here. For me, the 166M number is convincing enough, and I am confident to be taking a short position on that alone.
3. The current open interest on vanilla option contracts could reflexively impact the market in an asymmetrically negative manner as other catalysts unfold
It’s been a pretty long time since I looked at the impact of derivative market makers, but NKLA options are pretty heavily traded compared to average volume.
When a market maker sells a call option, they generally will delta hedge by buying and holding some amount of stock. As the stock rises, the chance the option ends up in the money goes up, and so they will buy more shares. As the stock price falls, the reverse happens, and they will sell some of their hedge. A similar effect happens with puts. When a market is made, the selling will delta hedge by selling shares short. As the share price drops, they will sell more shares short, and as the stock price rises they will buy some of their delta hedge back. Note that all of these are procyclical– the more shares go up, the more the market makers buy shares or cover their shorts.
So if we look at all the open interest in each option contract individually, we can back out the shares held for in delta hedging in aggregate at any given spot. We can then test how the delta hedging will change cumulatively across the market to adjust to delta risk. If we assume that 85% of option sellers delta hedge, and 3% of option buyers delta hedge, and we assume market makers delta hedge with the same implied volatility with which they price the options, then we can back out the amount of shares that are traded for any given move in the underlying.
The above chart makes the described calculation for all options (less the Nov 27th expiries). It depicts the change in outstanding shares used for delta hedging by option market participants by change in spot price. As the price rises, the change in share ownership is positive (indicating purchase of shares), and as it falls it is negative (indicating sales of shares). The downward slope indicates that as the as spot price drops lower and lower, option participants will need to sell more and more stock to delta hedge, where as the price increases, the amount of stock they need to purchase continually decreases.
This convexity alone may not be enough to crash the stock price alone, but this could be a compounding factor. If the market prices the stock down 3%, and we assume market makers only hedge once per day, ~700k net shares will need to be sold by option sellers hedging their positions– that equates to ~4% of average daily volume. As we assume higher intraday volatility, and higher hedging quantities, that number will slowly increase, and in reality could be a multiple of 700k shares.
How to profit
I’m looking at the middle term options. The December options aren’t as liquid as other months, but you get more direct exposure to the delta / gamma, while still benefiting from any cointegrated rise in vol. There are a couple things that make me comfortable to take a position here also. First, the implied vol is insanely high, and the vol term structure is upward sloping. So while owning a long term option you would usually see a Vega and Theta decay, in this situation the imp vol’s positive roll will actually offset some of that theta decay. Second, the vol smile is very steep. What this means is even if the position moves against me, the downside of OOM puts is stlil fairly limited, as my vol will go from 180% to 300%, decreasing the impact of the delta loss. Third, the moneyness of these options is still valuable, and taking the direct Delta exposure will still be very profitable if I’m right.
The assumption here is that this isn’t fully priced into option market makers imp vol calculations, which may not be fair. And in reality, I see two outcomes to the vol structure next week if this plays out, either (1) the market makers view, this is the largest risk, and the vol term structure should see a shift at all tenors as the risk dissipates, or (2) the market makers are slightly pricing this in, not fully, and the stock dropping ~5% or more will cause an added increase to vol in all tenors. The Nov 27th expiries do have a slightly lower vol (~120% ATM) so I figure these two forces could balance each other out somewhat– but it is still a risk to be mindful of. If I had more time, I would’ve loved to chat with a vol dealer to hear their pricing thoughts.
Anyway, I’ve executed a couple contracts at <1% of my portfolio in the mid December expirations, mid $20 strike puts, but will likely look for whatever vol is cheapest this Friday when the market opens next.
