After what seemed like a long wait for some anxious traders, options on Shake Shack (SHAK) commenced trading last week. The chart below is a depiction of weekly price action in SHAK since the company went public early this year. I can see why traders were clamoring for the listing of SHAK options.
Something in the SHAK option arena that has gotten a lot of attention is what appears to be a breakdown in put-call parity. Using options, a trader can create a synthetic long position in SHAK that has an effective price much lower than where shares are trading. The reason that put-call parity does not hold for SHAK option pricing is because the stock is difficult for short sellers to borrow. The common term for this is that SHAK is ‘Hard to Borrow’.
When a stock is hard to borrow the result may be a trader would having to pay to borrow the shares. Normally when a trader shorts shares they earn interest on the proceeds. When a stock is hard to borrow this rate of return may be more than offset by the cost associated with borrowing shares. Put-call parity relies on a trader being able seamlessly sell short shares. That’s not the case here.
This topic is one that definitely deserves an example. SHAK closed at 55.20 on Tuesday night and the final markets for the 55 strike SHAK Dec 2015, March 2016, and January 2017 (LEAPs) are displayed below.
To create a synthetic long position using options a trader will buy a call and sell a put that both have the same expiration date and strike prices. I used the offer side of each call and bid side of each put for the three expirations from above to create synthetic long positions in SHAK. Note that the put premiums are much higher than the call premiums so the trades were done at a credit.
In each of these cases the break-even level is much lower than the closing price for SHAK from Tuesday night. An illustration of this shows up in the payoff diagram below.
Note all three synthetic long positions are over 5 points to the left of the payoff that would be realized by purchasing shares of SHAK. Does this mean SHAK is a great short? Not necessarily, however, stocks that are hard to borrow tend to be more volatile than stocks that are easily shorted. As long as SHAK shows up on the hard to borrow list at brokerage firms, the excess volatility that is associated with shares of SHAK will probably continue.