Markets are littered with the wreckage that follows a bubble. Some market bubbles take years to develop. Other cycles may last for much shorter periods, and not all of them are created by the oft-described “Market Cycle of Emotions”. In a broad stock market bubble, stocks begin rising with optimism. As that optimism creates rising prices, the rising prices create excitement. Soon everyone wants in on the game and the market reaches its peak in a state of euphoria. Joe Kennedy and other well-known stock market speculators were said to have known to exit stocks when shoeshine boys and taxi drivers were offering stock tips. Eventually, as prices do fall, denial gives way to fear which gives way to panic and ultimately hopelessness; which will mark the bottom of the cycle and it will likely repeat.
However, short-term bubbles (and troughs) in individual markets may be fueled not only by enthusiasm by unwitting buyers, but also short-term structural supply (or demand) shortages. I refer to these supply and demand imbalances as structural, because often informed market participants recognize that an asset or security is grossly mispriced, but they have no means to act on their opinion and thus the price is dictated almost exclusively by either buyers or sellers and wild and arguably unwarranted price swings result. If investors or speculators believe a stock is overpriced but for structural reasons cannot sell it, then the price will be driven only by buyers and may rise wildly. Such as we’ve seen lately with cannabis, or “pot stocks”.
The quantity of stock available to buy or sell is not unlimited. Most investors are familiar with the terms outstanding shares or shares outstanding. These terms refer to the total number of shares that exist for an issue. Some percentage of those shares may not actually be available to trade. For example, shares held by insiders may be restricted, that is, those shares may not be sold. In the largest and most well-known stocks, this generally doesn’t make much of a difference. Consider Amazon (AMZN). Amazon has just under 488 million shares outstanding, and the “float” is 408.5 million, but the company trades an average of ~ 5.15 million shares per day; a volume that represents less than 1.3% of the float. So the amount of stock available to trade is significantly greater than the average demand to trade it on any given day. Put differently, the float is equivalent to nearly 95x the average day’s volume.
Such is not the case with some stocks though, and crazy stock of this past week, Tilray Inc. (TLRY) is a good example. Tilray Inc. has 76.5 million shares outstanding, but the float is only 10.3 million shares. That is less than the volume traded on the lightest trading day this week, Monday when TLRY traded 11.683 million shares. On Wednesday, the highest volume day, TLRY traded 31.718 million shares, or roughly 3x the entire float! Can you imagine if a car lot had an inventory of 100 cars, but sold 300 in a given day? That would mean that each car was sold 3 different times within a span of only a few hours. That kind of frenzy describes Wednesday’s trading activity in TLRY and helps explain the price swings.
If this was the only structural dynamic affecting the stock’s volatility that would be wild enough, however in the case of Tilray there was another issue, stock lending. Most active investors are familiar with the concept of short-selling or selling short. This is a transaction where a speculator bets that the price of a stock they do not own will fall. In this transaction, the short seller borrows the shares, sells them in the marketplace, hoping to buy them back later at a lower price at which point they will return the borrowed shares to the lender.
Short-sellers serve an important market function. They help stabilize prices by providing a supply of stock for sale when the demand to buy raises prices and existing shareholders either cannot or will not sell. Of course, short-sellers can only do this if they are able to borrow the shares in the first place, and in cases where the float is small, the available stock to borrow maybe even smaller. Such is the case with Tilray. When there is a shortage of stock available to lend to short sellers, a stock is said to become “hard” or even “impossible” to borrow. The market to borrow shares operates in much the same way as the stock market itself. As demand to borrow shares rises and supply dwindles, the fees that lending desks charge the borrowers, known as the “short rate” rise as well. In the case of TLRY, the short rate or borrowing cost is enormous. The cost to borrow shares in some cases exceeds 100% annualized if the stock can be borrowed at all. In the tightest lending markets, borrowers are forced to return borrowed shares on demand and are said to be bought in. In these extreme cases, borrowers do not get to hold their short positions until or if the price declines, they are forced by their brokers to buy the shares immediately, at whatever market price and return them to the lender. In these cases sellers can evaporate entirely, even those who wish to sell are forced to buy, and prices can spike. This scenario is known as a short squeeze.
Although most average retail investors may not have direct access to securities lending desks, evidence of hard or impossible-to-borrow conditions can be revealed not only by a stock’s price action but by options prices they observe in the marketplace. This is because options positions can be used as proxies for a short position in the underlying stock. For example one might choose to buy puts, giving the holder the right, but not the obligation, to sell a stock at a given price up to a future expiration date. Puts not only permit a speculator to take a bearish position without first borrowing the shares, a put also limits the risk in the event the stock rises sharply. Of course options market-makers will price options based on prevailing market conditions. If a stock is highly volatile, the options on that stock will be more expensive, and if a stock is hard to borrow, the puts will become more expensive than the calls. A quick look at Tilray options prices is very revealing. Let’s look at some examples.
TLRY closing price yesterday (Friday, September 21st) $123. The mid-market price of the September 28th weekly $123 strike calls was $16.30 and the $123 puts were $20.05. The straddle (adding both the call and the put) was priced at $36.35. The options market is implying TLRY is likely to move 30%, higher or lower in just 5 trading days. Also, the fact that the at the money put is more expensive than the at the money call reveals something else. That the “forward price” is lower than the “spot” (aka the current) price. How can we deduce this?
Consider the following structure.
Buy the Sep 28th $123 strike call pay $16.30
Sell the Sep 28th $123 strike put collect $20.05
An option trader who put on this structure would collect 20.05 – 16.30, or $3.75 at the time of the trade. What will happen at expiration?
If the stock is higher than $123, the call will be exercised, and the trader, because they are the holder will buy the shares at the $123 strike price. If the stock price is below $123, the put will be exercised, and because the trader in this structure sold the put, they will be assigned and “put the stock”, that is they will be obligated to buy the shares at the $123 strike price. In other words, regardless of whether the stock is higher or lower next Friday, the trader will buy the stock at $123, but because they collected $3.75 when they initiated the options trade their actual cost will be $119.25. That’s a 3% discount to the current stock price in just 7 calendar days. Because we know the options market will price in the borrowing cost, we can deduce from these prices that the cost to borrow the stock for this period is 3% per week or 150% annualized; and that’s assuming one could transact at something close to the midpoint of the bid/ask spreads.
Enormous borrow costs do not persist indefinitely. One of the reasons is that borrowers will not pay any price to borrow a stock so that they may sell it short. Whatever fees they pay to borrow erode the potential gains they may make. Although the cost to borrow shares for longer periods is higher in absolute terms, annualized those rates are lower. For example look at TLRY January 2019 $125 strike options (the $123 strike isn’t listed). The calls and puts are priced at ~ $30.75 and $57 respectively. At expiration, someone who bought the $125 call and sold the $125 put will buy the stock at $125 because either they will exercise the long call, or be assigned on the short put. Net of the $26.25 they collected on the options structure, the forward price is $98.75. Once again we can deduce that the implied borrow cost is 21% of the stock price over 118 days, or 65% annualized.
Some of these concepts can be tough to grasp at first, but one thing is clear. If you intend to buy and hold TLRY the options market provides a way to buy it far cheaper than the prevailing market price, and the options market is also implying a lower forward price than Friday’s $123 close. To better understand these, study the included charts of the implied borrow costs, short rates, and forward prices.
Image Source: Isabella Mendes, Pexels.Com
