Hard to Borrow Stocks

Hi, welcome to Options Physics. Today we are going to take a look at a very special and unique instance of put call parity, as it relates to options on stocks that are “hard to borrow”, and the opportunities that they can present for bullish investors.

In a previous episode of options physics, we covered the topic of carry. We talked about how in an environment with positive interest rates, if a stock is trading $50, then the 50 call should trade over the 50 put by the amount of interest money it would cost to borrow $50 until expiration. We illustrated this idea by giving the example of an arbitrage where market makers will buy call, sell put, sell stock and earn the short interest rebate.

Well, for this episode of options physics, we are going to say, hold on a minute, what if instead of EARNING a short stock rebate, the market maker had to PAY to be SHORT the stock? This can happen if a stock is hard to borrow. That means that there are more people who want to SHORT a stock than there are people willing to lend it out. Therefore, the people who want to lend the shares can charge a hefty premium. They take the cash as collateral for the shares, but rather than paying interest on the shares, they RECEIVE interest on that cash. Now, this type of activity has existed in the securities lending market for decades, but it used to be in less widely known securities. However, as the financial panic of 2008 progressed, more and more widely follow stocks became hard to borrow. One such security was General Motors, ever heard of it? It is because this phenomenon occurred in such a common name that we wanted to paint a picture for you.

To illustrate the situation, we are going to take a look at some option prices from the beginning of December 2008. At the time, there was a great deal of concern that GM was going to have to file for bankruptcy. GM’s bonds and stock were getting hammered. As a result, many people wanted to short GM stock, and so the PRICE to borrow the shares got to be very expensive. How expensive? Well, so expensive that if an investor wanted to BUY shares of GM, they could instead buy call and sell put and synthetically acquire the shares at a DISCOUNT to where they were in the market.

Specifically, at one point that December 2008, shares of GM were trading for $4.85. At the same time, the January 2009 5 calls were offered at 1.05, while the puts were bid 2.49. That meant that rather than buying the stock, a bullish investor who was certain they wanted to own the stock at least until January expiration 2009 could:

1) Buy the 5 call for 1.05

2) Sell the 5 put for 2.49

3) Net net, they collected 1.44

4) At January expiration they will either exercise their call or be assigned on the put, and pay $5, either way, they own the shares.

5) In the end they bought the stock for 3.56, or nearly $1.3 discount to the stock price!!

Sounds pretty good doesn’t it? Well, be careful. The math that we just did here is accurate, but be sure to recognize the important disclaimer: “certain they wanted to own the stock until January expiration”. That is part of the reason that buyers of GM at this time would let this relationship in the options continue to exist. They did not want to be tied down until January to get their long shares of stock.

That’s all for this lesson. I hope you’ve enjoyed this episode of Option Physics, see ya next time.