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Tilray Rallies Again: Anatomy of a Short Squeeze

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Yesterday, we reported on a remarkable rally in the shares of Tilray (TLRY - Free Report) in which the Canadian cannabis manufacturer rallied more than 30% in a single trading session and had now risen almost 900% since their July IPO.

On Wednesday, that almost unprecedented rally continued with the stock up 50% in intraday trading and now 1,250% above the price they were initially trading in public markets just two months ago.

Earlier in 2018, Tesla (TSLA - Free Report) CEO Elon Musk predicted that the “Short burn of the century” was imminent in shares of the electric automaker. Due to some fairly extreme price volatility, there have been many opportunities for traders to make and lose vast sums of money on Tesla on both the long and short side of the market - depending on the timing of their trades.

As far as short burns go, however, it looks like there’s a new sheriff in town  - Tilray.

The shares spent the first month after the IPO in a trading range about 25% above the offering price and looked like merely a “successful” new company in a hot industry.  Impressive, but not totally out of the ordinary.

Then a string of positive news items in August started to move the shares higher and investors eager to jump on the marijuana industry bandwagon began snapping up shares at higher and higher prices. Although the valuation didn’t make much sense by any conventional measure, buyers seemed to be focused on the potentially enormous size of the global cannabis market and Tilray’s chances of grabbing a big chunk of it over the coming few years.

At it’s core, the correct price for an equity investment is the discounted value of future cash flows, adjusted for risk.

For a stock like a utility – where future cash flows are known with great certainty, the stock price tends to mimic the price of a bond with the same risk. Any price volatility is due more to changes in interest rates than in changes in expectations about revenues or earnings.

For a mature large cap stock that maintains growth potential – like Microsoft (MSFT - Free Report) , future cash flows are far from certain, but analysts can still make pretty accurate estimates and price volatility in the shares still tends to be relatively low.

For a brand new company with scant history of financial results to examine but with an apparent foothold in a rapidly growing industry, future estimates are anybody’s guess and all sorts of prices can be justified. That’s part of what’s happening at Tilray.

It appears however that it’s a small part of the extreme price movement we’ve seen over the past few days. A much more plausible explanation is a good old fashioned short squeeze. Two specific factors are at play – a scarcity of shares to borrow to sell short and an unprecedented interest cost to maintain a short position are causing shorts to buy to cover their positions with little regard for price.

In large cap stocks with a huge number of shares outstanding and high liquidity, traders can buy or sell shares at will with little friction - and in most cases even earn a small amount of interest on the credit balance that results from a short sale.

In the case of stocks that are very hard to borrow in order to sell short, clearing firms and prime brokers will charge a trader interest to sell the shares, compensating the the brokerage for the difficulty of finding shares to sell. Typically that rate ranges from a few percent to 20-30% for very hard to find issues.

The short rate on Tilray went from 17% in August to over 200% earlier this month and now tops 400%.*

(note: these rates are not constant and vary from firm to firm, though they tend to move in unison across the brokerage community.)

That means that if you sold Tilray short, you’d pay 400% of the balance of the sale in short interest annually to hold the position. If TLRY went completely out of business with no liquidation value and the shares went to zero in three months, you would break even on the trade, having paid all of your profits on short interest. Suddenly the short squeeze starts to make sense.  Almost anyone would buy back those shares immediately as the possibility of a profitable short trade is almost zero.

Of course, very well-capitalized and bold traders might be able to hold on (or even initiate new shorts at these high levels) in the hopes that once the weak shorts have covered, the stock will tumble back to its previous levels, but that’s an extremely difficult trade to make – and certainly not for the average retail investor.

Even if you believe that marijuana is the best growth industry right now and that Tilray is the leader of that pack, this recent market activity indicates that most investors have no business being on either side of Tilray right now, long or short. It’s a blind gamble if you’re in it and pure entertainment if you’re not, but one thing it definitely is not is an investment.

*There will be a more indepth discussion of short rates and their relation to option prices Thursday morning in Zacks "Know Your Options"

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