Several readers have asked me to walk them through exactly how a percentage, or delta, hedge works in a real life example. So, here we go.
Over the next several weeks I’ll be doing a percentage hedge in Bank of America (BAC) common stock and the Bank of America Class A Warrants (BACWSA). I’ll be long the warrants and short either BAC common stock or call options. The terms of the Class A Warrants are: 1 warrant + $13.30 = 1 share of BAC common stock, with the warrants expiring 1/16/2019.
For those of you who aren’t able to trade intraday, or very often, I plan on posting both actual trades and proposed trades, or trades that can be placed via limit orders.
I will send an email out to everyone on my email list real-time when I make the actual trade. And, I will also post a weekly update each Friday with trades made that week.
I expect to do anywhere from 1-5 trades per week.
BAC is a great stock to demonstrate this strategy for a few reasons.
- It’s a fairly low priced stock and warrant,
- It trades in a pretty stable range, and has few large movements (both good and bad for us),
- It is easily shorted, and
- The warrants have a decent trading volume and a tight spread.
Over the course of the next few weeks I’ll talk about each of these characteristics in more detail and describe why they either help or hurt the percentage hedge trade.
The warrants currently trade at a $3.85 premium to the common, or $7.20 + $13.30 = $20.05, and $20.05 – 16.65 (the current price of the common) = $3.85.
We’ll start off with a 35% hedge (if the warrants were trading at parity our hedge would be 100%) and see how that works. We may increase or decrease that ratio as the trade progresses, but in general the percent will increase as the stock rises (we’ll short more stock) and decrease as the stock falls (we’ll cover our short shares).
My expectation is that we’ll be mainly trading the stock and rarely the warrants, but we’ll see how it plays out.
So with that, the first trade, which we’re executing today, February 28th, 2014, will be to pay $7.20 for 5,000 BACWSA and short 1,750 BAC at $16.65. I’ll put together a running Excel sheet to track all trades.
If you want to follow along in real time, and receive the trades as they are executed, simply subscribe by entering your name and email address either in the box on the right or at the bottom of this post.