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Bullish investors sometimes use conspiracy theories to account for stagnant or falling share price, when equally plausible non-conspiratorial and non-manipulation explanations exist. For example, the maximum pain theory finds that in the absence of news to create enough volume for sustained price movement, market makers and hedge funds keep shares range bound and drive share price towards a particular price. Apple's (NASDAQ:AAPL) Friday share price is an example since it will finish near the point of maximum pain on weak news. Sometimes it appears manipulated, and there are reasons to believe so including some below. However, there are also non-conspiratorial reasons for its movement including one or more investors acting independently.

Here I note significant amounts of reverse conversions, analyze the data, discuss patterns, suggest a reason, and explain how to profit through closer observation, while creating realistic daily and long-term expectations.

Market Maker, Hedge Funds and Reverse Conversions

The SEC allows market makers to naked short stock for bona fide reasons (i.e., maintaining liquidity). When hedge funds have difficulty finding shares to short, or if borrowing rates are high (due to high short interest), funds may turn to a market maker to borrow illegally their right to sell shares. Participants mask this transaction as a market neutral reverse conversion. The market maker sells shares (shorts) and an equal amount of stock put options to the short seller and also buys an equal number of call options to create a synthetic long position (Figure 1). The hedge fund is now free to short at will.

(Figure 1)


(Click to enlarge)

Some reverse conversions are legitimate and brokers may claim nothing is amiss and no phantom shares are dumped into the market. Yet, if the process is abused it may alter market dynamics between long and short positions. John W. Welborn, a former Haverford Group Economist noted that the SEC is concerned about abuse of the options market maker exception because "the manipulative sale of securities underlying a married put [can be] part of a scheme to drive the market price down and later profit by purchasing the securities at a depressed price." (Download here.)

Welborn elsewhere argues that large-scale reverse conversions and short selling distort markets and creates a "Phantom Shares Menace." Analyzing Overstock.com (NASDAQ:OSTK) he identified abuses that the SEC's Regulation SHO should have curbed, included: (1) "Engaging in securities fraud by knowingly failing to deliver securities; (2) Mis-marking intentionally short sales as long; (3) Engaging in market making activity that is not bona fide;" (4) "Failing to comply with Regulation SHO close-out requirements ('rolling the fails');" (5) Agreeing in advance not to demand delivery through buy-ins (i.e., criminal collusion)." Overstock was on the SHO threshold securities list (identifying naked short selling abuse) for over 600 straight days.

Finding Reverse Conversions

Large investors like to establish positions before letting retail investors move the price. Short sellers use several methods to mask their plans evident in reverse conversions. A typical reverse conversion involves out-of-the-money calls and higher than necessary puts. Strike prices and expiration dates are distant from the current price and date. Figure 2 a.-c. show conversions of Molycorp (NYSE:MCP) options using March $23, February $15, and May $10 strikes in late 2012, January and March, respectively, when share and strike price differed by $3.50 to $12.50. Short sellers also hid intent by breaking conversions into smaller and slightly unequal parts separated by minutes or more as I found common with Arena (NASDAQ:ARNA) (article in prep). They also use nearly invisible "micro" conversions (Figure 2 a. in part). Traders can hide conversions by trading in companies, such as Apple that have hundreds of strike prices per expiration date. A complete analysis of Apple would require an unknown program. Yet, Apple reverse conversions must be common since I find some whenever I look (Figure 2 d.).

Figure 2. Examples of Reverse Conversions

a. MCP March $23 Strike

mar23
(Click to enlarge)

b. MCP February $15 Strike

feb
(Click to enlarge)

c. MCP May $10 Strike

may 10
(Click to enlarge)

d. AAPL July $500 Strike

aapl 500
(Click to enlarge)

Results for Molycorp

Sixty-four reverse conversions occurred on 36 days between October 11, 2012 and April 16, 2013. The number of shares converted increased with share volume and were equivalent to 2,200 to 420,000 shorted shares per day (Figure 3).

(Figure 3)

Shorting Volume Numbers only
(Click to enlarge)

The "power" of the conversions was determined by comparing them as a percent of the daily volume. Their power varied from 0.2% to 7.9% of the daily trades (Figure 4) and they appeared most powerful at lower and mid-volumes. Importantly, the most powerful conversions (exceeding 1% of volume) occurred during option expiration weeks (55%). This is highly significant since the remaining 45% of high-powered conversions were scattered throughout the month (~15% per week).

Figure 4. Relative Power of Reverse Conversions

Shorting Relative to Volume
(Click to enlarge)

I determined the "effectiveness" of reverse conversions by (1) measuring the frequency that shares closed lower after a conversion and (2) determining if shares closed lower in any of the next three trading days. Results showed selling short through conversions was highly lucrative during options expiration weeks. Of the reverse conversions exceeding 1% of the daily volume, 85.7% closed lower on the day of trade if it occurred during the week monthly options expired. In contrast, only 55.6% of these closed lower during non-option expiration weeks. However, overall, 72% of shares closed lower within three days of a reverse conversion.

Potential Outlook

These companies have passionate a base of shareholders that see past any dark clouds due to their faith or long-term visions. Perhaps that makes them better targets for short sellers since each have a similarly large contingent of detractors who are assured they can keep the price fluctuating.

However, I may have put a damper on the profits of some who use reverse conversions, or alternatively market conditions did. Arena shareholders filed complaints with the SEC in March and April 2013. My complaint consisted of a long report filed on April 18-19, while stating I was submitting it for publication. Molycorp has since been reverse conversion-free. Arena was relatively free with only three reverse conversions in May, including two 17 minutes after a short-seller published an article on Arena. Reverse conversion activity for Arena also increased in the week leading up to Friday's launch of Belviq. I cannot determine if reverse conversion activity in Apple changed.

Share price improvement of Molycorp and Arena since mid-April could be completely independent of decreased reverse conversion activity, but studies suggest it will help. A George Mason University study found that the elimination of reverse conversions increases share price by making it more expensive for short sellers to borrow shares. Risks associated with shorting or writing options also increase due to uncertainty about the future availability of shares to protect short positions during expiration weeks or for curbing bullish enthusiasm on positive news. Thus, if reverse conversions indicates strong negative sentiment, the lack of conversions may predict higher share price.

Molycorp's difficult history began when the rare earth mineral price bubble burst. It now sits 91% off its high, excluding dilutions (Figure 5). Molycorp is not just a rare earth mining company with one of the free world's two largest rare earth mines. It is a vertically integrated company that develops and manufactures rare-earth products in facilities around the world that are critical for civilian and military purposes.

In 2012, Molycorp bottomed after the former CEO failed to live up to promises, including completing the chlor-alkali facility. That facility could make Molycorp the world's most environmentally friendly and cost-effective rare earth mining company. The delays in its completion created an opportunity for short sellers to profit.

But the tide may be changing in favor of the bulls. Under new management, the completion of the chlor-alkali facility is slated for summer 2013. The new management seems more trustworthy than the last one and we may have little reason to doubt their guidance. Expansion in 2012 (Project Phoenix Phase 1) greatly increased production capacity. If economy improves enough to cause a rebound in rare earth prices, Molycorp will complete the phase 2 to double production when they can benefit most from rising prices.

(Figure 5)

mcp
(Click to enlarge)

Similarly, Arena shareholders believe summer 2013 will be the key to their success. On Friday, June 7, Eisai (OTCPK:ESALY) begins marketing Belviq, a novel anti-obesity drug, that some predict will be highly profitable sold alone and a potential blockbuster if sold with generic drugs to produce results unlike anything seen since the 1990s (see here, here, here). While shares of most companies surge with good news and with the approach of a new product releases, Arena's will not budge at best and often falls with great news. Arena shares have dropped 21% this year and almost 28% since FDA approval of Belviq last year. The last time a drug with similar characteristics to Belviq was marketed, it was so popular it made the cover of Time Magazine, the most popular news weekly of its day.

Arena shares are down because pundits argued Arena would be out-competed by Qsymia, a new formulation of old anti-obesity drugs marketed by Vivus (NASDAQ:VVUS). Yet, after nine months of Qsymia sales, Qsymia appears to have flopped. You would think that helps Arena, but the same old pundits worry a similar fate awaits the novel drug, Belviq. Yet months ago, I showed that it is pretzel logic to compare these drugs since their characteristics and marketability are completely different. Shareholders eagerly await early sales data from channel checks in coming days.

Apple is almost 38% off its September 2012 high of $702 per share. The bearish trend may have ended when shares bottomed at $390 in mid-April. In an earlier article, I argued that Apple sits at a cusp of either competing in emerging markets or forfeiting a market projected to double in three years. We may see a new low-cost iPhone for emerging markets later this year. Until then, Apple can profit and expand its brand with a trade-in program for older phones that they will resell in emerging markets where there is demand for them.

Only the online retailer, Overstock, is up this year (by 79%) and is well above its two-year high. It is becoming increasingly profitable and its return on equity has increased. The Street even upgraded Overstock last week.

Conclusion

Taken individually, the reverse conversions could be part of a legitimate trading strategy. Together, the data suggests other possibilities including collusion between market makers and short sellers to obtain illegally and sell hard-to-borrow, highly shorted shares. The frequency of Molycorp conversions is so similar to the infamous Overstock case (10.7 and 11.7 per month respectively), it is easy to make other correlations. However, other possibilities exist. It could have also been worse. Arena suffered reverse conversions up to 22.7% of the daily volume (in prep) and with high-volume reverse conversions occurring several times a week.

My data does not discern if the conversions and short selling "significantly" affected share price under the SEC definition. Traders have a different definition of "significant" that centers on the stocks they trade, their immediate losses, not losses averaged with someone else's gains in another company. Remember, despite the elimination or reduction in reverse conversions for Molycorp and Arena, their shares still fell at options expiration in May, as expected under the maximum pain theory. Thus, other forces are involved, including non-conspiratorial ones.

Because weak regulation and enforcement allows large and persistent naked short selling through reverse conversions, we need to tighten rules. The market maker exception allows a broker-dealer to merely "locate" shares before shorting a stock and only needs "reasonable grounds to believe that the security can be borrowed" and delivered. This could allow for the shorting of two or more times the number of shares available. The short seller could borrow the located shares, before borrowing them again from another broker ad nauseum. The SEC seems reluctant to stop reverse conversions or create better rules because it finds abuses are tolerable and the manipulation is not "widespread," meaning it is okay for some investors to suffer more than their fair share.

Since Arena shareholders filed many complaints with the SEC about the reverse conversions, they appear ineffective. If they did act, why they waited until after I submitted my analysis is cause for speculation and I will let you suggest why.

Monitor your stocks. If you observe reverse conversions, limit your near-term expectations, perhaps trade like a hedge fund, or be patient, document events, consider your alternatives, and keep track of the availability of stock to short here.

Source: Is Molycorp Recovering From A Bad Case Of Reverse Conversions?