Until recently, most cannabis stocks were not liquid enough to short.
In fact, as of December 2016, their liquidity in the market was not even enough to support an ETF. The underlying liquidity of the components of an ETF was so low, experts argued, that whenever the fund opened or closed a position, the stock would experience too big a move.
More recently, however, the public has warmed up to marijuana stocks, even causing popular support for legalization of the drug to hit an all-time high in 2017. This has led to increased capital flows into the industry.
According to Viridian Capital Advisors' Viridian Cannabis Deal Tracker, which monitors M&A activity in the legal cannabis industry, the first 38 weeks of 2018 saw more than $5.67 billion capital raised for cannabis companies, more than tripling the $1.78 billion invested over the same period last year. That's not even counting the roughly $4 billion investment that Constellation Brands, Inc. (STZ) said in August it would make in Canopy Growth Corp (CGC) . The full investment has not been executed.
With the increased appetite for cannabis-related investments, it's time to ask the question again: Is there enough liquidity to short pot stocks yet?
Hedge Fund's View
Poseidon Asset Management, considered a pioneer cannabis-focused long/short equity hedge fund, thinks it can be done. Back in March, the firm's co-founder and managing partner Emily Paxhia explained that while shorting cannabis stocks remained quite difficult, it was already being done, especially in Canadian exchanges.
For instance, famous short-seller Citron Research called for shorts on British Columbia-based Tilray Inc (TLRY) and Toronto-based Cronos Group Inc (CRON) just a few weeks ago, driving short interest up briefly. Meanwhile, in August, Denver-based MassRoots Inc (MSRT) was involved in an episode in which someone impersonating an SEC investigator dialed into its conference call claiming the Commission was investigating the company. The firm's CEO Isaac Dietrich attributed the move to short sellers attempting to distract the market.
But probably the most interesting tale involving cannabis shorts to date, one that makes this piece timely, is that which emerged from Tilray the week ended September 21. In just three days, the firm's stock went from gaining 50% on September 19, on the back of bullish comments by its CEO Brendan Kennedy about partnering with the world's largest pharmaceutical companies as a "hedge" against the space, to closing down more than 30 percent two days later. The wild swings set off investors and analysts discussing the dynamic of trading low float stocks, among other things.
Speaking to The Street, Poseidon's other co-founder and managing partner Morgan Paxhia explained there are certain periods of the year when liquidity is better.
"Sometimes liquidity is driven by more people in the market, usually around certain material events happening in the industry. During those periods of time, we have the ability to short stocks," he said.
Think of recent news like those of The Coca-Cola Co (KO) considering a foray into the space, or the potential lifetime ban to enter the U.S. that Canadians working and even investing in the industry could face. Following this news, we saw higher-than-usual trading volumes in companies like Tilray and Aurora Cannabis Inc (ACBFF) . Now, one thing was made especially clear with Tilray's Odyssey: even when trading volumes are high, the float of cannabis stocks remains limited, making it hard and expensive to short them -- with borrow rates surpassing 450% on Tilray's stock last week.
The Perils Of Shorting Illiquid Stocks
Although liquidity in the cannabis market is starting to pick up, the danger of getting trapped is still very real.
"A short squeeze can destroy people, especially due to the capital requirements to place a short," Poseidon's Paxhia warned, noting the extremely high borrowing rates.
"Liquidity is certainly an issue," Viridian Capital Advisors vice president Harrison Phillips agreed, when prompted about the topic. Furthermore, the high borrowing costs make it hard to make short trade profitable, he added, quoting that old Keynesian that "markets can stay irrational a lot longer than you can stay solvent."
While Poseidon cannot disclose its past or present shorts, Morgan Paxhia notes the fund has completed dozens of successful shorts.
"We've often used options to express a bearish position. But this only applies to companies on big exchanges. So, even though the universe is growing and getting more efficient, it is still small," he told The Street.
Down this line, John Kaden, CIO of Navy Capital, the other well-known hedge fund in the cannabis industry, explained that these equities are "tough to short because borrow is inconsistent and very hard to get in size. Also correlations among the group are still above 80 percent. But once recreational market begins in Canada, the stocks correlations will come down and individual stock fundamentals will matter more," he concluded.