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What's Happening to Option Prices During the Tilray Short Squeeze?

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Over the past few days, we’ve documented the meteoric rise lately of shares in Tilray (TLRY - Free Report) , the Canadian marijuana company that has rallied more than 1,200% since its July IPO. 

Read about it here>>  and here>>

Though strong investor demand for shares in the booming cannabis industry is certainly part of the reason for the incredible rally, the more likely cause is specific market mechanics regarding short sales.

By the end of the day Wednesday, Tilray shares had been halted by the NASDAQ exchange 5 separate times for extreme volatility, and after briefly trading as high as $300/share, closed at $217.75/share. (In fact, the stock did not even really “close” in the technical sense of the term. That was simply the last traded price before the final trading halt at 3:48pm EDT. More volatility can almost certainly be expected when the shares reopen for trading on Thursday.)

The trading action during the day was as volatile as we’ve seen in any stock for a long time, even going as far back as the financial crisis ten years ago. For most of the day the movement was straight up, though the trading halts seemed to allow sellers to gather strength and push the price back down

The options markets give us some insight into the main reason for the unprecedented rally and rapid price movement in the stock this week.

First we have to revisit the concept of call-put parity.

There’s also a more thorough discussion of the concept here>> and here>>

You’ll recall that the price of a call, minus the price of a put with the same strike and expiration date, plus the strike price must equal the future price of the stock. The future price is defined as the current price plus the cost of carrying the stock to expiration, minus any dividends paid during that period.

The equation assumes that we can borrow money (to buy stock) or lend money (to earn interest on the proceeds of stock sold short) at a single interest rate, which is not exactly true, but it’s close enough for this example.

C – P + K = F

If the market prices violate call-put parity, a trader could buy the call, sell the put and sell the stock, (or do the opposite of all three trades if the mispricing is in the opposite direction), then simply hold all three positions to expiration and lock in a risk-free profit.

Because of the obvious appeal of arbitrage profits, mispricings like this happen very rarely and don’t last long.

Let’s take a look at a deep, liquid stock like Apple (AAPL) and the market prices of relevant options just before the close of trading on Wednesday:

Stock price: $218.50

Options:

                                                Bid                       Ask

OCT 215 Call                       $7.95                     $8.05

OCT 215 Put                        $4.10                     $4.20

 

Using the midpoints of the option bid-ask spread and plugging them into the call-put parity equation, we get:

8.00 – 4.15 + 215 = future price

218.85 = future price

That would imply a time premium of $0.35 on top of the current stock price to arrive at the future price, which implies an interest rate of 1.9% annually – a thoroughly reasonable number given where short term interest rates currently are.

So in the case of Apple, arbitrage free call-put pricing is evident, just as we would expect.

Since Apple does not pay a dividend before the options expire, here's how to calculate the interest rate:

Apple stock price * (days to expiration/days in year) * interest rate = cost of carry.

218.50 * (30/365) * 0.019 = 0.35

 

Now let’s take a look at Tilray option prices today:

Stock price: $220

Options:

                                                Bid                    Ask

OCT 215 Call                       $41.00                   $44.00

OCT 215 Put                        $86.00                   $89.00

Again using the midpoints of the option bid-ask spread and plugging them into the call-put parity equation, we get:

42.50 – 87.50 + 220 = future price

175.00 = future price

In this case, the futures premium seems to be negative $45. Assuming an interest rate of 1.9%, a trader could buy the call, sell the put, sell the stock and collect $45, then simply wait for expiration to sell the stock at $220 and keep the $45 (plus $0.35 in interest) as risk free profit, right?

Wrong. Because the correct interest rate is not 1.9%

In illiquid stocks that have a high amount of short interest, clearing firms and prime brokers often charge customers on a percentage basis to find shares that can be borrowed and sold short. In the case of Tilray, that percentage went from 17% annually at the end of August, to 200% last week, and to over 400% this week.

With only 9M out of the total 75M shares outstanding and huge demand in short selling this high flying and – by many measures – massively overvalued stock, there are almost no shares available to borrow and sell.

Those who are short Tilray and want to cover have to find a price at which someone who already owns the stock wants to part with it. Those who are lucky enough to be long can simply sit on their hands and wait for higher prices, safe in the knowledge that the market is full of desperate buyers and a relative scarcity of sellers, because initiating a new short position is difficult if not impossible.

It will probably take some time for the markets to sort out the inefficiencies and Tilray will remain volatile until that happens. Eventually, traders with losses will cover their positions and lick their wounds and traders with profits will find it irresistible not to lock them in and will close up and go on vacation. When that finally happens however is anyone’s guess.

Trading Application

The above was mostly an explanation of what’s happening in Tilray stock and options rather than a specific trading idea, but it does provide an important insight into trading stocks that become hard to borrow during a short squeeze.

Let’s say that for whatever reason, you want to buy Tilray stock right now. Maybe you’ve decided that it’s going up from here and want to be long (yikes, be careful) or you’re already short the stock and want the pain to end (sorry), but buying shares in the open market is a terrible idea. Because of the negative premium on the future price that we described above, you can buy it much cheaper using options.

If you buy the OCT 220 call for $42.50 and sell the OCT 220 put at 87.50, and when those options expire, you will definitely buy the stock for $220/share. Either the call you own will be in the money and you’ll exercise it, or the put you’re short will be in the money and it will be assigned to you, but either way, you’re buying shares for $220, but minus the $45 you already collected on the options spread. Your net price would be $175.

Keep in mind that if you were to open a long position in this manner, you wouldn’t be able to close it and keep that $45 until after expiration. If you’re closing a short position, it’s a no-brainer.

Even some professional traders don’t understand this concept. Certainly anyone who’s covering a short position in the open market rather than with options is giving away cash. Especially when things get weird, there’s often a way to use options to make smarter trades.

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