Read This If You're Thinking Of Buying Put Options On Tilray

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About: Tilray, Inc. (TLRY), Includes: TSLA
by: Logan Kane
Summary

A seemingly large percentage of options traders don't fully understand put/call parity and how options are priced.

This causes them to lose money trading.

This article is intended to help traders understand some of the math behind options trading, with popular cannabis stock Tilray as an example.

A somewhat popular trade right now is to be short Tilray (TLRY) via put options. Fundamentals aside, I believe that the risk/reward does not currently support this trade from an options pricing perspective, and I'll explain why.

When trading stocks, it's possible to be 100 percent right on your thesis and still lose money. This is doubly true for options, which require you to be right in both the timing and direction of moves in stock prices. Options, in general, are priced by market makers who hedge their positions with the underlying stock and earn arbitrage-like profits by providing leverage to speculators. In the case of Tilray, this mechanism breaks down due to the small float available for arbitrageurs to short the stock.

Because of arbitrage activity, if a stock is trading at $100, the $100 strike puts and calls should be approximately equal in price. This is called put-call parity (further explanation and mathematical proof here). Options are priced to be agnostic to the expected return of the underlying asset, and instead, are priced against volatility, the LIBOR, dividends in underlying stock, and short-sale borrow rate. Market makers continuously hedge their options positions with positions in the underlying stocks to keep this in balance, as when the price of the options get out of whack with the stock, they can make nearly riskless profits by selling the overpriced assets and buying the underpriced assets. This can't happen for Tilray at the moment due to the relatively small number of shares that trade on the open market.

The Case of Tilray

Tilray is an interesting example of how options pricing works because it's a "violation" of put-call parity. The violation is easily explained, however, by Tilray's high cost to borrow for short sellers, which impedes arbitrage (and price discovery in the underlying stock).

Tilray–Cost to Borrow on Interactive Brokers

Source: IB Borrow Desk

As you can see, to short Tilray currently, you're required to pay an annual interest rate of 831.6 percent. I'm sure there are some envious loan-sharks who would like to get in on this, but that's the current rate to sell this stock short in the public markets.

Side note, but if you have an Interactive Brokers or Fidelity account and have Tilray stock, you can contact them about lending your share to short sellers, and you and your broker would be able to split the proceeds 50/50.

If you don't have this privilege and own shares in cannabis stocks, there's a good chance your broker is doing it behind your back and is pocketing the money, courtesy of the fine print of your account agreement.

That's a story for another day.

Anyway, a lot of options traders think they're getting around borrowing the stock for short selling purposes by buying options.

Not so fast!

I took a look at TLRY February 15th options with my old E-Trade account for a quick take, and the $95 puts (the nearest strike) are trading for about triple the price of the calls. The roughly $15 per share difference is the "interest" you're paying. The short-borrow rate may go down in the future, but it is not guaranteed in the slightest to come down in any reasonable period of time.

Tilray February 15th Options Chain

Source: E-Trade

Just to be clear for everyone, you're not getting around paying the short borrow rate by buying options. This applies to every hard-to-borrow stock out there, whether it's companies like Tesla (TSLA) in years past or marijuana stocks in the present.

For those who want to learn more about options pricing and price performance, academic research shows that in the broader market, call options have positive (and volatile) expected returns and put options have negative (also volatile) expected returns. This is because call options are derivatives of long stock positions, which have positive expected returns, and put options are derivatives of short stock positions, which have negative expected returns over time. The returns also depend on whether the options are in or out of the money, with out-of-the-money and long shot bets having worse odds on average.

As such, calls are mostly used as a vehicle to speculate on share prices rising, and puts are mostly used as insurance.

Conclusion

There are lots of reasons to be skeptical about marijuana stocks. However, buying puts and/or shorting Tilray is prohibitively expensive. The safest place to watch this battle is from the comfort of the sidelines. With speculation abounding around Tilray's lockup expiration and whether or not they're going to sell any shares in the foreseeable future, it's tempting to place a bet.

If I had Tilray shares, I would sell them immediately due to the hype and complete failure of the business to support the valuation, unless, and only unless, I were profiting handsomely from short sellers borrowing my shares (institutional investors like hedge funds typically get far more than 50 percent of the short borrow rate so it's a better deal on that side). Even at the retail rate, the idea of securities lending combined with low-float stocks changes the dynamic a lot and needs to be investigated more as a trading strategy. To this point, shorting stocks like Tilray is likely not a profitable endeavor once borrow rates (and implied borrow rates for put options) are taken into account.

Maybe some commenters who participate in securities lending programs can weigh in below!

If you're betting on Tilray to go down, even via options, remember that the stock needs to go down more than the borrow rate costs for you to make money. No matter which side of this trade you're on, knowing that you can profit from securities lending from your trading on the long side and knowing that the borrow rate costs you on the short side and is priced into put options will help you make better trading decisions.

Good luck to all!

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.