This guide is derived from many years of experience owning and trading warrants. The focus of this particular guide is on short term trading of stock warrants and how to profit from repetitive patterns that occur in the common stock and warrants of publicly traded companies.
If you’d like an even more detailed guide of how to make money with warrants check out my eBook, Grow and Protect Your Money with Stock Warrants. There you’ll find additional information on the strategies I discuss below as well as other profitable strategies not discussed here.
Some warrant trading strategies can make a profit instantaneously. Other strategies are based on common patterns that occur over the life of a warrant. After reading this guide you’ll know how to trade warrants in three ways:
- Warrant arbitrage
- Trading around a hedged warrant position, and
- Trading a hedged warrant position using a percentage hedge
You can make money trading all three ways, and with much less risk than a simple buy and hold strategy.
As a side note, many of the strategies we’ll talk about can be used to trade rights offerings or convertible preferred stock.
And with that introduction let’s get to it…
Classic arbitrage involves buying a warrant and simultaneously selling short either the common stock or an option on the common stock. Let’s take an example of a warrant with a very simple and straightforward exercise term.
Our warrant can be exercised for $5 to get one share of common stock. Therefore, if the common stock is trading at $10 the warrant should logically trade at $5. One warrant trading at $5, plus an additional $5 of cash, is equal to the value of the stock at $10.
Normally the warrant will trade above $5 because the warrant will trade with a time premium just as an option does. The longer the period of time until expiration the higher the premium.
While it is less frequent today than it was even a few ago, there are times when this is not the case and the warrant trades at a discount to the common. For our example, this would mean the common is trading at $10 and the warrant is trading at some price less than $5.
When this happens, the trade is fairly simple. Buy the warrant at less than $5 and short the common at $10.
Let’s say we can buy the warrant at $4.75 and short the common at $10. We’ve now made a guaranteed $.25 on the trade. If necessary, and this is not ideal because we’ll see in a moment how we can make additional money in this trade, we can simply exercise the warrant.
By sending $5 to the company along with the warrant we purchased for $4.75 we will receive one share of common which will offset our short position which we established at $10. Net result, we’ve sold common stock at $10 and are now covering that short at $9.75 for a $.25 gain.
The Warrants Must Be Exercisable…
Now, don’t rush out and find a warrant that is trading at a discount and believe you’ve found Blackbeard’s treasure. There are two very important caveats to this trade. First, the warrants must be exercisable.
If you find a situation where a warrant is trading at a substantial discount to the price of the common stock (meaning the price of the warrant plus the exercise amount is substantially less than than the current value of the common stock) it is highly likely that the warrant is not exercisable.
So, how do we handle this situation? First, we call our broker and ask if the warrant is exercisable. If they look it up on Bloomberg and see that it is exercisable, great, then we move to the next step.
Second, we call the transfer agent to ask if the warrant is exercisable. Your broker should be able to tell you who the transfer agent is for the warrant as well. What the heck is the transfer agent?
When a broker is directed to exercise a warrant they do not actually send the warrant and money to the company itself. This back office function is performed by a transfer agent.
This agent is tasked with ensuring the correct documents are filed by the company, getting the cash to the company, and getting the stock to your broker. The transfer agent should know if the warrants are covered by a current registration statement filed with the SEC and therefore should know if the warrants are exercisable.
In a scenario where your broker and the transfer agent tell you the warrant is not exercisable, the third step is to contact the company that issued the warrant to ask if they will file a registration statement in order to make the warrants exercisable.
Do not overestimate the level of knowledge around warrants or stock at the issuing company. I’ve personally spoken to a CFO who did not even know what exchange his company’s warrants were trading on.
The CFO may not be aware that they need the registration statement. With a simple call (or email) you may be able to get the company to register the warrants in order for them to be exercisable.
The Stock Can Be Shorted (or Has Options)…
After we ensure the warrants are exercisable, next we find out if the stock can be shorted. If the stock is borrowable, we have no issue. Your broker should allow you to short the stock. Often stock is borrowable, but you may have to pay interest to borrow it. You must do the math to make sure this rate does not eat away all of your arbitrage profit.
If the stock cannot be shorted, a second option is to trade against your warrants using options (pun intended). Call options can be shorted against the common with the same profit of shorting the common. You’ll be looking to short deep in-the-money calls with little to no premium.
However, and this is a very important caveat, shorting calls against warrants may not create the same hedge as shorting common. We can go into detail on this in another article (if it is a subject you’re interested in then comment below), but since we’re focusing on warrant hedging against common stock we won’t dive into option arbitrage here.
Another drawback to this method is that the options may be exercised, making you short the common. If this occurs your broker will likely have to go into the market and buy back the common because you cannot carry a short position in the stock. This may, and often does, take away our arbitrage profit.
Trading a Hedged Warrant Position
As we said before, it is not ideal to exercise a warrant to close a short position in the common, even if the position was originally put on at a profit. There are times when it may be necessary to exercise the warrant.
You may need to exercise when you know you are going to be bought in on your short position, or you need to use the capital the position is tying up for other purposes. But, if you can carry the position, you may have an opportunity to make further profit from what has already been a profitable trade.
Let’s continue with our previous example. We’ve purchased a warrant for $4.75 that is exercisable for one share of common stock at $5, and we’ve shorted common stock at $10 locking in $.25 of profit. It’s quite possible that at some point, we will be able to take this position off at an additional profit.
Let’s assume the stock moves to $9. The warrant may move to $4.25. If this takes place we can cover the common stock we shorted at $10 for $9, making $1 of profit. We can simultaneously sell the warrants we purchased at $4.75 for $4.25 losing $.50, for an overall profit of $.50.
More often than not you’ll find that you are putting on positions (buying warrants and shorting common) as the stock is moving up, and taking off positions (covering short common and selling warrants) as the stock is moving down.
Advanced Strategies for Hedged Positions
There are times when it is advantageous to leg out of, or take off, one side of a long warrant / short common position, and maintain the other side. While it is risky to sell the long warrants and hold a short position, you can trade into a long warrant only position that has been more than paid for by your previously hedged position. Let’s run some numbers using our example from above.
What if the common stock you are short against your long warrants moves from $10 to $3? How does that impact your positions?
The common stock will show a profit of $7, or $10 minus the $3 cost to cover the short position. The warrant will move down some amount depending on the time value left in the warrant and the volatility of the common. For our purposes, lets assume it moves to $.50.
The profit / loss on this position now looks like this:
- $10 – $3 = $7 profit
- $4.75 – $.50 = $4.25 loss
- $7 – $4.25 = $2.75 net profit
Now, lets leg out of the position by covering the short position in the common at $3 but not selling the warrants.
With a profit of $2.75 the worst case scenario at this point is that the $.50 warrant we are long goes to $0 reducing our profit to $2.25. If the stock rallies from $3 we will profit as the warrant moves up. The common can be re-shorted against the warrant, or the warrant can be sold to capture additional profit.
The Percentage Hedge
In our previous examples we used a one-for-one hedge, or we shorted one share of common stock for each warrant we purchased. We could also call this a 100% hedge. In the previous examples we used a warrant that was trading at a discount to the underlying common. But what if the warrant is trading at a premium (which in most cases it will be)?
Let’s continue with the same terms as in the example we used above. One warrant plus $5 will give us one share of common and our common is trading at $10.
That means if our warrant is trading under $5 it is trading at a discount, if it is trading at $5 it is at parity, and if it is trading over $5 it is trading at a premium (again, the most common example you’ll find in the real world).
In order to explore the percentage hedge we’ll say our common stock is trading at $10 and our warrant is trading at $6, or a $1 premium. If we were to do a 100% hedge at these prices we would sell the common short at $10 and buy the warrant at $6, in essence buying a stock (by way of the warrant) at $11 and selling it at $10. Unless your last name is Madoff it’s highly unlikely you’ll make money this way.
How to Employ the Percentage Hedge
Here we’ll break out the percentage hedge, buying some number of warrants and shorting some fewer number of shares of common against our warrant position. The question we have to ask here, and this is the tricky part (who said trading was EASY??) is “how many common shares do we short against how many warrants?”.
First, it will be some percentage less than 100%. Second, the best way to determine this percentage is to have traded, or tracked, the common and warrant for some time in order to become familiar with how the stock trades.
Third, the smaller the premium the heavier the hedge and vice versa. There is definitely some art involved in determining how heavy or light the percentage hedge should be.
For our example, we’ll say we believe at a $1 premium that a 75% hedge is appropriate. For every 100 warrants we purchase we will short only 75 shares of common. This gives us our initial position.
Stock / Warrant Movement in a Percentage Hedge
Now that we have a position let’s see what happens as the stock first moves up and then as it moves down. Assuming we make no further trades (we’ll get to trading around the position in just a moment) if the stock moves from $10 to $11 we will lose $1 on 75 shares we are short, or $75.
We’ll assume our warrant moves from $6 to $6.50 so we will make $.50 on 100 shares or $50. Our percentage hedge will likely show a small loss as the stock moves up.
Now what if the stock moves down immediately after we have on our initial position? We’ll say the stock moves from $10 to $9 and our warrant moves from $6 to $5.50.
In this scenario we will make $75 on our short position in the common (75 shares x $1.00) and we will lose $50 on our long warrant position (100 shares x $.50) for a profit of $25. We can take the trade off at a profit here if we want, or wait for the stock to drop further in which case we will realize more profit.
So, if we put on a percentage hedge we have a belief (and hope) the stock will go down? Actually, it’s just the opposite, we want the stock to move up so we can increase our hedge as it does so. Let’s see how that looks.
Trading the Percentage Hedge
As the stock moves from $10 to $11 and the warrant from $6 to $6.50 the premium is shrinking. As we said above, as that premium shrinks we want our hedge to be heavier. So here we increase our hedge from 75% to 85%.
To do this we short an additional 10 shares of common at $11, bringing our position to long 100 warrants and short 85 common shares. (In reality you might short 2 shares at $10.25, 4 at $10.50, 2 at $10.75 and 2 at $11 to get to the 85% hedge, but for the sake of simplicity, in this example we’ll assume we short all 10 shares at $11.)
Now we have the same $25 loss, but we are now short 85 shares of common and long 100 warrants. If the stock continues higher, we would short additional shares until we were closer and closer to a 100% hedge. But, we’re going to assume here that once the stock reaches $11 it drops back to $10, where we put on our original position.
With the stock back at $10 and the warrants back at $6 we are even in our 75 short common and 100 long warrants. But, we have a profit on the 10 shares that we shorted at $11. We cover those shares at $10 and now have a $10 profit (10 shares x $1).
What we would like to see after we put on our initial hedged position is the stock moving up (where we will short additional shares) and down (where we will cover the shares we shorted as it rose) and up and down over and over. This will give us the opportunity to profit as the stock rises and falls.
As you can see from the examples above, stock warrant arbitrage offers an opportunity to profit from the movement of a stock without knowing in which direction that movement will be. This can be a very effective trading vehicle for a trader when you either do not have a feel for which way a stock will move, or if you wish to limit your risk in a trade. As I mentioned above, if you’d like even more information on making money trading warrants check out my eBook, Grow and Protect Your Money with Stock Warrants.
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