Pay Attention to Hard to Borrow Rates, Even in Options Trades

Last week, we took another look at call-put parity and the last part I mentioned was that the calculation gets complicated when a stock becomes “hard to borrow.”

Be careful, it’s more expensive than you might think, whether you sell the shares or buy puts.

Shares of Canadian marijuana producer Tilray (TLRY) currently have significant short interest and are very hard for brokers to borrow so that their customers can sell them short. It currently costs an average of 55% annually if you want to maintain a short position in the stock.

This means that traditional options strategies are going to cost significantly more or less than you’d otherwise expect.

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

Last week’s article on the concept is 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 Microsoft (MSFT) and the market prices of relevant options on Thursday:

Stock price: \$145.50/share

Options:
JAN 140 Call                        \$7.25                                   \$7.35
JAN 140 Put                        \$2.63                                    \$2.68

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

7.30 - 2.65 + 140  = future price

145.65 = future price

That would imply a time premium of \$0.15 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.

Since MSFT will pay \$0.51 in dividends before the options expire:

Microsoft stock price * (days to expiration/days in year) * interest rate – dividends = cost of carry.
144.65 * (71/365) * 0.019 – 0.51 = 0.02

So in the case of MSFT, arbitrage free call-put pricing is evident (or at least within a few cents – mostly because of bid-ask spreads), just as we would expect.

Now let’s take a look at TLRY option prices today.

Stock price: \$22.00

Options:
JAN 20 Call                          \$3.45                                   \$3.65
JAN 20 Put                           \$2.75                                   \$2.85

TLRY does not pay dividends, so we can leave that part out.

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

3.55 – 2.80 + 20 = future price

\$20.75 = future price

In this case, the futures premium seems to be negative \$1.25. Assuming an interest rate of 1.9%, a trader could buy the call, sell the put, sell the stock and collect \$21.25, then simply wait for expiration to buy the stock at \$20 and keep the \$1.25 (plus 7 cents in interest) as risk free profit, right?

Wrong.

In illiquid stocks that have a high percentage of short interest, clearing firms and prime brokers charge customers on a percentage basis to find shares that can be borrowed and sold short. In the case of TLRY, that percentage is now between 40% and 70% annually.

With relatively few shares outstanding and huge short interest, there are almost no shares available to borrow and sell.

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

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

Let’s say that for whatever reason, you want to buy TLRY stock right now. Maybe you’ve decided that it’s going up from here and want to be long or you’re already short the stock and want to cover, 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 JAN 20 call for \$3.55 and sell the JAN 20 put at \$2.80, when the options expire, you will definitely buy the stock for \$20/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 \$20, plus the \$0.75 you paid for the options spread. A \$1.25 discount to buying the shares in the open market.

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 \$1.25 until after expiration. If you’re closing a short position, it’s a no-brainer - though it would be preferable to use options that expire sooner.

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

It also means that buying those 20 puts is not a cheap or easy way to get short.  Because of the negative interest rate, the stock would have to decline 22% - to \$17.20 - before you see the first cent of profit.

-Dave

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Disclosure: Officers, directors and/or employees of Zacks Investment Research may own or have sold short securities and/or hold long and/or short positions in options that are mentioned in this material. An affiliated investment advisory firm may own or have sold short securities and/or hold long and/or short positions in options that are mentioned in this material.

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