Mysterious Trading Dynamics With VirnetX

Tom is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Have you ever suspected a stock that you own is a target for manipulation?  The share price gets pushed around. Message boards and investor forums are infiltrated to spread negative views as if they are facts.  Traders and investors are fed a steady stream of fear, uncertainty and doubt, making one believe the stock is over-valued. This article is meant to shed some light on the rollercoaster ride of investing in volatile stock movements, such as my investment in VirnetX. An understanding of the ride may help you hold onto your shares of volatile but successful companies, ignoring the “noise” of short sellers..

There are powerful forces that are able to control and manipulate the share price of publicly traded companies. In regard to VirnetX (NYSEMKT: VHC), there are 15,033,619 shares that are documented as being "short." I have observed what appears to be synthetic shares created and then sold into market to either lower VirnetX's share price or cap a rally.  The biggest risk for short sellers is that a single positive binary event, such as the Judge issuing a final judgment against Apple (NASDAQ: AAPL), a settlement from a litigant or non-litigant, a buy-out or a dividend can seriously spring VirnetX to higher ground. These scenarios will be explained in this article.

Preface: This article's publication is meant to shed some light on the witnessed reverse conversions and the potential manipulation of the share price of VirnetX's stock. It is also written to inform people who want to understand the practice. The wild ride with VirnetX's stock is clear to those who are dedicated investors. For those who are not investors I have compiled a list of some trading days where the price was exacerbated through the use of synthetic shares created through reverse conversions. It provides insight to the wild share price ride.

●  January 16, 2013: Shares Down 3.3% on 1,857,228 shares traded while on public message boards a VirnetX patent was allegedly invalidated by the Patent Office. In reality there was a non-final action and all claims will be reviewed. The patent remained fully intact and enforceable.

●  December 20, 2012: Shares Down 5.85% percent on 3,358,696 shares traded as post trial motions were heard before Judge Davis. The judge ordered Apple to provide updated sales data for certain unaccused and accused products, including the iPhone 5 by January 15, 2013. Kendall Larson stated "We look forward to the updated sales data from Apple so the Court can make an informed ruling on our request for judgment." This added request by the judge provides for a better informed decision by Judge Davis; more informed judgments are less likely to be appealed.

●  July 26, 2012: Shares down 18.1% on 5,088,964 shares traded as Special K (now known as Value Bulldog) published an article titled "Do You Believe in Fairytales? Part 1." This article was used as sensational news firepower for shorts with fake shares to drive down the price of VirnetX, through guessing on what would happen without any compelling tangible evidence. Answering the four numbered parts in the article now;

1  VirnetX was victorious at trial against Apple.

2  VirnetX was awarded a large amount against Apple with a second trial against Cisco and Avaya pending.

3  At first Apple stated that their workaround would cost a few million dollars and take a few weeks. In post trial motions they stated it would take 18 months and be very expensive to implement the workaround. So it seems there is a disconnect between what Apple stated at trial and in their post trial motions.

4  The presiding judge in this case, Chief Judge Leonard Davis, is one of the most experienced intellectual property judges in the Federal Court system and has an exemplary track record with the Court of Appeals.

Many of the days with downward pressure have a headline or article associated, but in reality were non events.  The most powerful short sellers used these inaccurate stories to unload their fake shares to drive down the price. 

A positive binary event, such as a settlement or positive judgment, could lead to a big increase in the share price for VirnetX. This would push those who are short to go into the market and obtain the shares that they would have to deliver. Keep in mind that VirnetX's average daily volume is 953,269 shares, with more than 15,000,000 shares short and an unknown number of synthetic shares sold into the market. The price increase of the stock, coupled with the amount of shares needed to close out the various short positions, would put additional pressure on the positive uptrend.

The number of shares short have recently been on a modest decline due to management's successful execution of their strategic plan.

An announced dividend would also hurt those short or manipulating VirnetX's stock even more. Those who are short are forced to pay the dividend to whomever purchased the stock.  In addition, reverse conversions create the synthetic shares that are sold into the market (naked short) with the dividend having to be paid by those who sold those shares.  This could cause massive losses for those major short sellers. Moreover, dividend reinvestment would reduce the number of legitimate shares available on the market, thus making the stock harder to short since shares would be harder to obtain, borrow and short. It would also be harder to keep these shares short if a quarterly dividend was enacted since the shorts would have to pay this four times per year.

Reverse conversions are on the more manipulative side of the trade.  Investopedia.com defines a reverse conversion as "A finance and risk management technique based on a put-call parity strategy that consists of selling a put and buying call (a synthetic long position), while shorting the underlying stock. As long as the put and call have the same underlying, strike price and expiration date, a synthetic long position will have the same risk/return profile as ownership of an equivalent amount of the underlying stock."

I have witnessed the execution of reverse conversions to create more shares for those who want to short the stock, but do not have access to inventory. They sell these shares to themselves so they are not available for others to borrow and do not appear on the figures regarding shares available to short. In a reverse conversion, it is actually the market maker who is short the shares of the stock. Then the short seller sells the shares that he just bought from the market maker rendering the calls he just wrote as naked. The rules only allow the market maker thirteen days to be naked short. To circumvent that rule it's possible the market maker has another market maker use their own exemption so as to create shares he can buy to close his short. Although, in the case of an increase in price, the market maker has to close out their short position by obtaining shares through the calls they bought in the reverse conversion trade.

Some people ask why would someone have to go through all of this just to profit from a decrease in the price of VirnetX stock. The answer is that this situation is the alternative when there are not enough shares to borrow or they are too expensive to borrow. There are two sides to the situation, that being the short seller and the market maker.

The first party in this situation is the market maker who is in the game for the profit earned through commissions and earnings. The call protects the market maker from a rise in price and he is protected from a drop in price due to the shares he is short. The put closes out the shorted shares if the price drops when shares are put to the market maker.

Market Maker

Motive: Commissions and earnings

Rise in Price Protection: The call

Drop in Price Protection: Shares Short

End Game Closes out the shorted shares when shares are put

Manipulation: Use created shares to influence the share price

 

The Market maker is short the stock, using the exemption not having to borrow. The market maker covers when he exercises that call that he made the person sell him who wants the created shares so the short seller can use them to influence the market price. This influence can be used as manipulation by selling the shares to kill rallies caused by positive news or exacerbate bad trading days.

Short Seller

Motive: Obtain shares too expensive to borrow

Long: Long the stock, long the put

Short: Short the call

Exposure: None until shares are sold

Manipulation: Selling the created shares, affecting the price.

 

The short seller is long the stock, long the put and short the call. The short seller has no exposure until he sells his shares in the market, thus affecting the price. Even though the short seller can affect the price negatively, if the price were to rise he would have to go into the market and purchase shares to cover the call that became naked when he sold the stock he received.

At this point those short have to (as discussed earlier) go into the market and purchase stock to deliver against the calls that were exercised. The number of shorts, coupled with the number of shares they would need to purchase, and mixed with a buying raid to cover their positions would lead to a massive increase in share price. Its one thing to have a normal market of buyers and sellers with a stock price that goes up in value, but its another when every short seller has to cover their then naked calls when the market maker exercises the calls against the short seller's naked call position.

The idea is a lot to grasp, although it is happening at VirnetX. Maybe a hedge fund was down slightly and decided instead of covering to just add to their short position. Or a fund thought VirnetX would not be able to prove infringement of their technology, assert their legal standing and develop their company so they wanted extreme profit at the stock's downside. They were looking for profit that was beyond simply shorting shares of the stock. To the defense of the short sellers, VirnetX was a David and Goliath story. How could some little company take on the technology giants of the world? As the story has unfolded, the reasons to be short have so diminished as to become non-existent.

If I may play devil's advocate, I feel there is no hard evidence of reverse conversions in black and white. Although, if evidence was that easy to find it would not be going on. Sometimes the instance of a reverse conversion can be found if there are very big, duplicate trades at an equal strike price for both the calls and puts. The idea is hard to track, but any long-term VirnetX investor can attest to the manipulation in its price per share.

A recent example of these manipulative reverse conversions occurred on January 15, 2013. In the options market for VirnetX, two thousand puts and calls were traded using the $40 strike price with a March expiration. Traders are expecting an Apple appeal 30 days within a February final judgment. This appeal will likely keep the share price below $40 so they would not have to go into the market to obtain the shares to satisfy delivery against the calls that would in essence, be naked. While all this is going on, there are 200,000 shares that were used to quash rallies and exacerbate declines.

On January 18 2013, those on the short side created 170,000 shares using a strike price of $40 using calls and puts that expire on Feb. 16. The shorts are becoming more exposed to risk since a final judgment from the Honorable Judge Davis would send shares higher, meaning the shorts would have to go into the market to obtain shares to cover their position. These real shares would be hard to find in a tightly held stock such as VirnetX, leading to a positive uptrend in shares. Not only would this cause the stock to decline once the newly acquired shares are sold into the market, but it also serves to keep the stock below the strike price of the calls already written in the prior reverse conversion to preclude having to deliver shares on exercise.

Evidence of the manipulation of VirnetX's share price is well known by the market. Author John H. Ford wrote a compelling article about a bear raid on the stock that took place on August 3, 2012. He stated in his article

"In the case of the recent VirnetX share price drop, the cause is attributable to short seller manipulation. Misinformation and obfuscation scared investors, hence the massive selloff."

John H. Ford was well aware of the bear raid that took place in the past, yet he stayed long VirnetX. The company has a bright future, there is no reason to give into bear raids and give up your shares based on emotion.

This article was not meant as a specific step-by-step guide to identify reverse conversions and manipulation, it is meant to be an abstract on the manipulation affecting VirnetX stock regarding a secretive practice. The manipulation affecting VirnetX's stock is a wild ride, although a settlement, ruling, dividend, buy-out, or any other positive event such as a litigant taking a stake in VirnetX can trigger a massive short squeeze rendering the price gain larger than normal since short sellers would have to go into the market to cover their short positions. Some reasons the short seller argument has faded are:

VirnetX settled with Microsoft for $200 million in 2010.

• VirnetX has already triumphed over Apple in a court where every single claim was accepted for $368 million. The Judge now has every document and a final judgment can occur at anytime.

• An injunction against Apple is a possibility, more likely more negotiation power for VirnetX as discussed in my first article here.

Cisco and Avaya are on schedule to go to trial in March, (this has not been postponed).

Siemens has recently settled on 1/29/13 for a one-time payment and future royalties.

• NEC, Mitel and Astra have also settled.

• VirnetX's patents are continually confirmed by the USPTO, such as on 1/25/13 when 12 more patent claims were confirmed for VirnetX's '759 patent.

• Gabriel Connection Technology will be rolled out in the next six months to one year.

• "In December 2009, VirnetX announced that it had declared to the 3rd Generation Partnership Project (3GPP) 23 patents and 28 patent applications as being "essential" to Advanced 4G wireless standards." (Moreno 7).

• VirnetX's essential patents can be described as "device patents," which cover how secure real-time communications will work on next-generation networks. They will license these patents on FRAND-based terms to product manufacturers. But VirnetX also owns "service patents." These patents cover the services required to manage secure domain names globally. This licensing model is not obligated by FRAND-based commitments and should generate a significant amount of revenue.". (Moreno 12)

• VirnetX owns the Secure SIP model.

For the reasons stated above, VirnetX is becoming a more and more distinguished company each day. They have proven technology and they have successfully fought for their right to collect on their inventions with Apple and Microsoft. One of the worst things an investor in VirnetX can do is sell their shares on a down day, giving them up. On the next day that VirnetX is down more than usual, look past the headline and try to find a substantive reason for the decline in price; you most likely will not find a good one.

Although most long investors only pay attention to the very successful long-term goals of the company, manipulation in share price on a day to day basis is frustrating. VirnetX will have a significant role in the future of 4G communications and secure domain services. Whatever the reason short sellers have not begun to cover is beyond common knowledge, although their bets have proven wrong and continually pulling on the bottom of an elevator that's going up will leave them hanging when it gets to the top.


Note: This article has been posted on my blog and has received over eighty-five recommends, it can be viewed here

 

 

 


toms119 has a long position in VirnetX Holding Corporation. The Motley Fool recommends Apple. The Motley Fool owns shares of Apple. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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