Reverse Conversions

[liane]

I am somewhat knowledgeable about options, but I'm trying to get to the bottom of the reasoning here - so maybe someone can help me out. Yesterday and the day before, there were option plays called reverse conversions. The definition from Investopedia:

"Definition of 'Reverse Conversion'
A finance and risk management technique based on a put-call parity strategy that consists of selling a put and buying call (a synthetic long position), while shorting the underlying stock. As long as the put and call have the same underlying, strike price and expiration date, a synthetic long position will have the same risk/return profile as ownership of an equivalent amount of the underlying stock.
Investopedia Says
Investopedia explains 'Reverse Conversion'
In a typical reverse-conversion transaction, a brokerage firm short sells stock and hedges this position by buying its call and selling its put. Whether the brokerage firm makes money depends on the borrowing cost of the shorted stock and the put and call premiums, all of which may render a return better than the money market with very low risk. In the context of futures markets, a trader would be synthetically long and short the underlying futures while looking for arbitrage opportunities. "

On Wednesday, there were 2000 Jan14 13C and 2000 Jan14 13P traded. On Thursday, same thing, but 3000 of each. The options alone are a synthetic long position - no matter what happens to the stock price, you will own the stock at 13 - whether the calls are in the money, or you have the shares put to you. The overall math works like this:

Short 100 shares at ~ 5.80 yesterday         +580.
Sell 1 put (100shares) ~ 7.60                    +760.
Buy 1 call (100 shares) ~ 0.20                     -20.

Net                                                        1320   (13.20 per share - enough to cover the strike)

No matter what happens, you will own the stock and have to pay the 13 strike if you hold the position to expiry. But you still have the short position at 5.80 - which you can cover with these shares obtained through the options, and still have a net .20 per share (minus commissions). So there is NO risk. But, on the surface, there is very little gain (.20 per share). And therein lies my question.

What this whole exercise does allow you to do is short when either shares are unobtainable or the borrowing costs are too high. As you can see from the above math, the net take is almost zero. But it does allow an overall large short position on the stock (500,000 shares) at no risk. This will hold down the share price. Soooo.... my thoughts are that someone wants to hold the price down in the near term to load up - maybe for Deerfield to get their shares? Anyone else have any ideas?

[liane]

Here's an SA article re reverse conversions in some other favorite manipulated stocks:

seekingalpha.com/article/1487732-is-molycorp-recovering-from-a-bad-case-of-reverse-conversions

[bobw]

Buying the call and shorting the put at the same strike is like entering into a forward contract. If you also buy a zero coupon bond with a face amount that is the same as the option strike that matures at the same time as the option expiration, it is the same as buying the stock and is known as a synthetic long position in the stock.
C - P + K*B = S

B is the price of a zero coupon bond that pays $K on the expiration date of the options.
K is the strike of both the call and the put.

If C - P + K*B is less than S, it is an arbitrage and you can make a riskless profit by buying the call, selling the put, buying a zero coupon debt instrument that is worth $K on the option expiration and shorting the stock. If the pricing of the calls, puts and stock gets too out of line, someone will take the arbitrage profit, but it is likely an institution because their transaction and borrowing costs are lower and they can lock in the profit with lower price discrepancies than an individual investor can. It is also an arb if C_P+K*B > S; you would just make the reverse trades to lock in the profit.

I wouldn't read too much into this type of transaction other than that something was mispriced.

Another reason that for this activity could be that someone bought a straddle struck at $13 (long the call and long the put). A long straddle with a strike that is well above the stock price will make money if the stock price goes down because the put has a larger delta than the call. It will also make money if the stock price goes very high (the call delta keeps increasing while the put delta decreases). This trade seems less likely because it is struck so far from the stock price.

Normally a straddle is used to play volatility, but the strike has to be close to the stock price. In this case going long a straddle is going long volatility. You are hoping for a large price change but don't have a view on the direction.

[babaoriley]

Nice summary, bobw!

[liane]

bobw,

I do agree that it exploits a mispricing of the options. Would you agree that this type of move also creates short shares when they otherwise might be unobtainable or expensive?

[bobw]

Anytime an option is created (from a net new buyer and seller) both a long and a short position is created. It does not create short shares. When a call expires in the money, either:
1) a buyer and seller exit their positions with offsetting trades which has no effect on the stock
2) or the short delivers shares to the long. In this case if the short does not already own the shares he must buy them in the open market before delivering. As far as the stock market is concerned, it is the same as the long call holder purchasing the shares.

Of course the reverse is true for puts. So, I guess you could say that a naked short put can turn into a short stock position.

As far as it creating short shares when they are expensive (I think you really mean too cheap), the arb should never get that large that it would make that much difference that the price discrepency would influence someone to hold short shares if that was not already their intention.

You are correct that you can create a synthetic short position if the short shares are not available, but that also means that synthetic long shares were also created.

[MnkdMainer (MM)]

Bob, do you agree that the stock price can be artificially depressed in the manner Lia has described? I ask because this was my impression from Lia's posts, but you understand this better than I do, and I do not follow everything you have said.

[bobw]

MnkdMainer, I am not an expert on trading, but here is my take on it. Anytime you sell shares, you tend to move the price down, but generally it will only push the price down for a limited amount of time. Also, as the price moves down, new buyers tend to enter the market, limiting the movement, that is unless you can cause a panic. The question I would ask first is how do you know that the person that transacted in the shares also shorted the stock?

Over the two day period, it is stated that 5,000 puts and 5,000 calls traded. That is equivalent to options on 500,000 shares. In the longer term, how much can shorting 500,000 shares affect the price? There are already about 47 million shares shorted.

I am not convinced that Deerfield is manipulating the stock price so that they can cheaply exercise the conversion. They do have reputation risk and that kind of behavior is not conducive to making deals in the future. I think that the reason that Deerfield wanted the conversion feature was to try to mitigate the losses that they would have incurred if Mannkind had released bad trial data in August. It is not in their interest to harm Mannkind because they are on the hook for an additional $120 million in loans. It is virtually a given that the next two tranches will be purchased and the third if the FDA approves. If the market loses confidence in Mannkind and the share price drops below $2.60, the warrants will not get exercised and Deerfield will be subject to considerable risk.

[fedakd]

Sept 3, 2013 20:56:13 GMT -5 bobw said:

MnkdMainer, I am not an expert on trading, but here is my take on it. Anytime you sell shares, you tend to move the price down, but generally it will only push the price down for a limited amount of time. Also, as the price moves down, new buyers tend to enter the market, limiting the movement, that is unless you can cause a panic. The question I would ask first is how do you know that the person that transacted in the shares also shorted the stock?

Over the two day period, it is stated that 5,000 puts and 5,000 calls traded. That is equivalent to options on 500,000 shares. In the longer term, how much can shorting 500,000 shares affect the price? There are already about 47 million shares shorted.

I am not convinced that Deerfield is manipulating the stock price so that they can cheaply exercise the conversion. They do have reputation risk and that kind of behavior is not conducive to making deals in the future. I think that the reason that Deerfield wanted the conversion feature was to try to mitigate the losses that they would have incurred if Mannkind had released bad trial data in August. It is not in their interest to harm Mannkind because they are on the hook for an additional $120 million in loans. It is virtually a given that the next two tranches will be purchased and the third if the FDA approves. If the market loses confidence in Mannkind and the share price drops below $2.60, the warrants will not get exercised and Deerfield will be subject to considerable risk.

With the reverse conversions still continuing in MNKD, I thought it would be a good idea to bring back this thread. Unfortunately, we now can see that that over the longer term, shorting via reverse conversions has added many, many, many, many more short shares to the stock. The stock is therefore being artificially suppressed as a result. This is not okay and I've since asked a question on Quora to gain a better understanding and to get the message out. 

www.quora.com/unanswered/How-does-the-MNKD-short-position-get-unwound-Its-been-the-subject-of-major-put-call-asymmetry-due-to-short-selling-reverse-conversion-arbitrage?__snids__=1606111845&__nsrc__=2


I also encourage everyone to read liane's posted SA article that details Molycorp's reverse conversion experiences. The parallels it has with MNKD are uncanny!

[matt]

So long as puts and calls are available on the same underlying with the same strike price, there will be no price arbitrage possible with the possible exception of pennies due to transaction costs. If there was a price difference, a savvy investor would create a synthetic security with options and bonds and take an offsetting trade in the real security pocketing the difference.

However, if the demand to create short shares via synthetics was large enough it would move the option price and destroy the price parity. While it may be possible that somebody out there is creating naked synthetic shorts, there can't be too much of that activity without moving the market for the underlying in the opposite direction. That is the entire basis of arbitrage pricing.

[fedakd]

January 2017 ITM options have almost zero premium. Literally, like a few cents. This doesn't make any sense and it is a result of the major short interest and reverse conversions that have continuously driven this stock down.