Reverse Hedges Strategy

Reverse Hedges strategy involves the short sale of overpriced expiring warrants combined with the purchase of the underlying common stock. The warrant is a wasting asset, and this hedge captures the premium while at the same time provides a wide band in which the stock can trade without causing a loss in the position.
The basic strategy is straightforward; common stock is purchased and overpriced expiring warrants are sold short. When the number of warrants sold short equals the number of stock purchased, the hedge is similiar to covered Call writing. The number of warrants shortened compared to the number of common shares purchased is called the hedge ratio. Increasing the ratio has three effects: it lowers the downside breakeven point, it lowers the upside breakeven point, and it increases the return in the case where the stock is at the exercise price when the warrant expires. A 2:1 ratio is frequently a good starting point for determing the hedge ratio. In calculating the profit profiles it is helpful to know that they are always triangular in shape (except when the hedge ratio is 1:1), and that the maximum profit always occurs at the exercise price, and that the profiles have a common intersection.

Affect of Hedge Ratio Changes on the Profit Profile

best warrants hedges strategy

Two simple formulas assist in rapid determination of the upside and downside breakeven points:

reverse hedges

A = downside breakeven S = stock price B = upside breakeven W = warrant price R = hedge ratio E = exercise price

Beginning in December 1992, the common stock suffered extreme selling pressure as unanticipated bad news unfolded and the public liquidated shares with abandon. The warrant price, although sharply lower, did not fall as much as might be expected under the circumstances. The warrant was overvalued, the primary requirement for a succesful hedge, and the impending expiration insured that the warrant would be forced to its intrinsic value within a known time frame.

A preliminary analysis showing the lower and upper breakeven points and the maximum profit for various hedge ratios is shown in table below.

Hedge

Ratio

Lower

Breakeven

Upper

Breakeven

Maximum

Profit

1

20

0 (1)

$3,500

2

10

100

4,500

3

0

83

5,500

4

0 (2)

77

6,500

(1) The profit profile is horizontal and thus never enters negative territory.
(2) A profit occurs if the stock price is $0. True breakeven would be hypothetical – $10.

In this data a hedge ratio of 2:1 was selected because it provided protection well in excess of price extremes anticipated for the Warner Communications common prior to expiration of the warrant. A detailed analysis of the 2:1 reverse hedge is shown in Table above..
A year later the stock was trading at the 23 level with the warrants near 2.5. Before commissions, this represented a $7,000 loss on the common and a $15,000 profit on the warrants. When a hedge matures nicely as this one has done, the hedge should be reevaluated in terms of its remaining potential. If the hedge is attractive as a new position it should be retained; otherwise, it should be closed.

Reverse Warrant Hedge Table

Buy 1,000 WCI common at 30.00 = $30,000
Sell 2,000 WCI warrants at 10.00 = 20,000
Commissions = 920
Net Investment = $30,920

Risk/Reward Analysis

Assumed stock price

10

30

55

100

Estimated warrant price

0

0

0

45

Profit (loss) stock

(20,000)

0

25,000

70,000

Profit (loss) warrant

20,000

20,000

20,000

(70,000)

Income received

3,500

3,500

3,500

3,500

Margin interest

0

0

0

0

Commissions

(1,170)

(1,395)

(1,535)

(2,675)

Total gain (loss)

2,330

22,105

46,965

825

Return on investment

7.5%

71.2%

151.9%

2.7%

Analyzed ROI

(3.36 years)

2.2%

21.2%

45.2%

0.8%