How fund managers are scrambling to catch up, fuelling the cannabis trading frenzy

For some pot investors, big windfalls have turned into big problems.

Tilray became a market darling after going public in July on the Nasdaq exchange at US$17. Since then, its shares have steadily soared before a wild ride this week. Its stock touched US$300 on Wednesday – and was halted several times over the course of the day – before closing at US$214. On Thursday, shares finished the day down another 18 per cent at US$176.35.

Over those two trading days, more than 50 million shares were traded on the Nasdaq. The company only has about 10 million free-trading shares, or “float.”

Still, Tilray is the world’s most valuable cannabis company, with a US$16-billion market capitalization – greater than that of Barrick Gold Corp. and about the same size as that of Power Financial Corp. The company, which is based in Nanaimo, B.C., sells medical marijuana products to patients in 10 countries and is gearing up to sell recreational cannabis in Canada come Oct. 17. Tilray is 76-per-cent owned by Privateer Holdings Inc., a Seattle-based private equity fund that owns a number of cannabis firms.

A number of funds and wealthy individuals bought Tilray and other cannabis stocks when the companies were private, often for pennies a share. These investors typically agreed to hold shares acquired ahead of an initial public offering for a period of four months or more, following IPOs.

As Tilray and other cannabis stocks soared, some investors took steps to lock in their gains and avoid any potential losses that would come with a market correction, according to sources at fund managers and investment banks. They short sold other cannabis stocks, so any losses on positions in Tilray and other locked-up holdings would be offset by gains on stocks that declined in price. Or they used strategies that involved the options market to limit risk, selling other investors the right to buy, or “call,” cannabis stocks from them at a preset price for a preset time.

These strategies blew up because shares in every large cannabis company are soaring, leading to significant losses on short positions and certain options-based strategies. And the investment banks that facilitate these trades for hedge funds, known as prime brokerages, typically will not accept shares with trading restrictions as collateral on investments. This eliminates a client’s ability to offset losses on short positions or options investments with winning investments in locked-up shares.

In recent days, sources say a number of prime brokerages took steps to cover losses on their clients' cannabis investments, buying shares to close short positions or selling their clients' remaining cannabis holdings to cover losses. This buying and selling of shares in Tilray and other cannabis stocks was a major factor in the frenetic recent trading activity, according to banking sources.

The losses have sometimes been compounded by the fact that Tilray, which has relatively few shares outstanding, was actively short sold going into this week. The scramble to close these positions in the face of significant losses contributed to the recent spike in the stock price, according to sources at investment dealers.

In its July IPO, Tilray sold nine million shares, raising US$153-million and valuing the business at US$1.6-billion. Wells Fargo, Fidelity and T. Rowe Price are some of the blue-chip holders of its shares.

The shares started to spike in mid-August as traders speculated about which marijuana company would be the next to ink a deal with a major consumer brand, after Constellation Brands Inc. announced its plans to invest $5-billion in Canopy Growth Corp. of Smiths Falls, Ont.