U.S. Markets closed

What Was Behind Tilray's Wild Ride Yesterday

Todd Campbell, The Motley Fool

Shares in marijuana company Tilray Inc. (NASDAQ: TLRY) went on a roller-coaster ride yesterday that likely left many investors with whiplash. In the final hour of trading on Wednesday, Tilray's shares went from nearly doubling to a loss before settling in with a 38% gain. The crazy volatility during the final hour resulted in trading in Tilray's shares being halted five times. Here's what you ought to know about today's wild ride.

Triggering circuit breakers

The stock market has created circuit breakers to rein in runaway markets and prevent stock crashes. These circuit breakers aren't designed to prohibit investors from trading stocks, but they are in place to help slow down the pace of trading so that all market participants can execute their buys and sells in an orderly way.

A man with eyes open wide looks at a computer monitor.

IMAGE SOURCE: GETTY IMAGES.

In Tilray's case, wide swings in its share price triggered the Securities and Exchange Commission's "Limit Up-Limit Down mechanism."

This specific circuit breaker is activated if a stock trades outside of "a specified price band." The band is a percentage above and below a stock's average price over the preceding five minutes. Specifically, if a stock trades outside of the band by a fixed percentage (10% for S&P 500/Russell 1000 stocks or 30% for other securities trading above $1 per share) for 15 seconds, then trading in the stock is paused for five minutes.

The bands double "during the opening and closing periods of the trading day" to offer additional protection from swings caused by premarket activity or pre-close decision-making.

What caused Tilray's volatility

Tilray's crazy day is an example of what can happen when pent-up demand, rising short interest, and market-moving catalysts converge.

Until recently, U.S. investors had few marijuana stocks to choose from on the major U.S. stock exchanges. Cronos (NASDAQ: CRON) up-listed to the Nasdaq and Canopy Growth (NYSE: CGC) up-listed to the New York Stock Exchange earlier this year, but it wasn't until Tilray's IPO on the Nasdaq in July that investors could pick up shares in a brand-new offering.

Tilray's IPO helped unleash demand from institutions prohibited from buying over-the-counter stocks, and as a result, Tilray's shares have marched steadily higher since its IPO. However, the increase in its share price has attracted bearish investors who have increasingly been betting that Tilray's multibillion-dollar valuation is untenable given its annualized sales total of less than $40 million.

TLRY Short Interest Chart

TLRY Short Interest data by YCharts.

In September, those bearish bets have been put to the test as optimism for marijuana stocks has increased ahead of the opening of Canada's recreational marijuana marketplace next month and amid rumors that consumer goods companies, including Coca-Cola (NYSE: KO), have been knocking on marijuana companies' doors about collaborations.

The tug-of-war between bulls and bears appears to have come to a head today. Double-digit percentage increases in Tilray's share price, coupled with sky-high borrowing costs for short sellers, prompted a short squeeze that sent Tilray's share price as high as $300 (a 94% gain on the day). When the selling stopped and traders eagerly booked their intraday windfall, it caused Tilray's stock to tumble 150 points in the span of about an hour at the end of the trading day. 

It was that sell-off that triggered the SEC's Limit Up-Limit Down rule. The first five-minute pause in trading happened when shares dropped from $300 to about $230 in a 10-minute span between about 2:50 p.m. EDT and 3 p.m. EDT. Then, as shares continued falling toward their intraday low of $151.40, trading was paused four more times between 3:20 p.m. EDT and 3:45 p.m. EDT.

When all was said and done, Tilray's stock finished the day up 38% at $214.06 with over 31 million Tilray shares changing hands. For perspective, average daily trading volume on the stock is about 8.1 million shares.

TLRY Price Chart

TLRY Price data by YCharts.

What to do now?

Industry watchers think the marijuana market could be worth over $200 billion globally in 15 years, but Tilray's already trading at over 500 times its annualized quarterly revenue, so much of its opportunity may be factored into its current share price.

Its valuation might have you tempted to sell short shares in Tilray, but as fellow Fool Sean Williams recently pointed out, the borrowing costs associated with doing so are high. Additionally, because short-selling exposes investors to unlimited risk, betting against a high-momentum stock like Tilray is particularly dangerous.

Instead, you're probably best off viewing Tilray's crazy day as a reminder that short-term trading can be perilous and watching this stock from the sidelines for now.

More From The Motley Fool

Todd Campbell has no position in any of the stocks mentioned. His clients may have positions in the companies mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.