Tesla's Index Entry Is a Two-Sided Coin

NEW YORK (TheStreet) -- Tesla Motors (TSLA) shareholders have the top down, wind blowing in their hair, a charged battery, and a sun-soaked day as they cruise Wall Street at a closing high of $123.44 Tuesday.

Tesla shareholders have plenty of company to keep the party going. Shares in Ford ( F) also hit new 52-week highs this week, and the new General Motors ( GM) isn't more than a car length behind. Tesla has more than an improving automotive sector to thank.

Gaining entry into the Nasdaq 100 Index / PowerShares QQQ ( QQQ) raises the stature of the company. Other companies on the top 100 list include Apple ( AAPL), Google ( GOOG), and Cisco ( CSCO).

List inclusion guarantees new buyers of the stock. Index funds will sell the soon-to-be departed Oracle ( ORCL) shares as Larry Ellison's company goes to the NYSE Euronext ( NYX) and use the funds to purchase shares in Tesla.

List inclusion isn't a totally free ride, though. Shareholders busy popping corks and celebrating Tesla's entry into the index may not have thought about the darker side of inclusion. At the same time funds are rebalancing positions out of Oracle and into Tesla, other funds, notably short-selling hedge funds, are reviewing their positions, too.

Undoubtedly, some short sellers are willing to throw in the towel, lick their wounds, and walk away. But I'm not referring to those funds. I'm referring to the funds with a long-term short bias opinion that can maintain their short positions indefinitely without worrying about finding borrows or interest.

Yes, the index membership coin has two sides -- one side increases the demand for shares and the other side decreases the obstacles of shorting. Let me explain how "normal" short selling works, and then how "synthetic" short selling works, and it will make sense.

Normally, in order to short a stock, the seller must find shares he can borrow, and if he is able to locate shares, he sells the borrowed shares on the market. The investor can subsequently buy, and return the shares anytime, but sometimes the lender wants the shares back earlier than expected -- the owner can request the return anytime -- and the short seller must deliver the shares, either through finding another party to loan shares, or through purchasing shares on the open market.

The costs of borrowing and the risk of a forced position liquidation sometimes will stop short sellers from initiating and or maintaining/increasing a short position. In the case of Tesla, almost half the float was shorted, and borrows were incredibly difficult to locate, not to mention the high fees loaners of shares received. In short, life wasn't as awful as it appeared for short sellers, it was worse. Not only did they lose money as the shares rose in value, they paid a high interest rate to borrow the shares. That's about to change, though.

Short sellers can soon short Tesla without the above-mentioned inconveniences. They will use a strategy called "a synthetic short." Option traders understand this concept, but there is another way that doesn't include options. For example, by shorting QQQ and buying all the stocks in the index EXCEPT the shares hedge funds want to short, the hedge funds effectively short the excluded stocks.

If a hedge fund wants to short 10 stocks within an index, it shorts the QQQ and buys the other 90 stocks. The 90 stocks and the QQQ will rise and fall relatively the same. The difference in profit or loss comes from the direction of the 10 stocks not purchased to hedge the QQQ position.

The Final Takeaway:

Hard to borrow lists probably won't include Tesla much longer, and short sellers are free to fire at will. With shares of Tesla reaching 52-week highs and index funds creating new demand for shares, short sellers may want to look for another target.

At the time of publication the author had no position in any of the stocks mentioned.

This article was written by an independent contributor, separate from TheStreet's regular news coverage.

Robert Weinstein currently blogs, mentors traders, and writes several weekly columns in Rocco Pendola's Option Investing newsletter from his home in northern Wisconsin. Robert tends to focus on the psychological importance of goals, risk mitigation, emotion, and relatively short term market exposure. With nearly 30 years of studying and investing experience, Robert has experienced the many ups and downs in the financial markets and uses the knowledge gained to maintain balance. Robert believes the best way to make money investing is to avoid losing it. The best way to avoid losing is to know what emotional traps lay in the path of investors and learning how to avoid them. Robert is a voracious reader of financial related books often completing more than one book a week while not trading or writing. Robert contributes to his blog at paid2trade.com on a regular basis with an emphasis on studying behavior finance.


More from Opinion

Apple Needs to Figure Out Its Self-Driving Vehicle Strategy

Apple Needs to Figure Out Its Self-Driving Vehicle Strategy

Throwback Thursday: Tesla, Chip Stocks, TheStreet's Picks

Throwback Thursday: Tesla, Chip Stocks, TheStreet's Picks

12 Stocks That Our Writers and Their Sources Recommend You Buy Here

12 Stocks That Our Writers and Their Sources Recommend You Buy Here

Musk Goes on Unoriginal Media Tirade

Musk Goes on Unoriginal Media Tirade

What's Happening in Video Games This Week: On the Road to E3

What's Happening in Video Games This Week: On the Road to E3