Stock Warrants Trading Strategies

One goal any investment strategy is the identyfication of undervalued and overvalued situations. A consistent program involving purchase and sale of such issues should allow an investor to outperform the market over the long term. Since the warrant’s price value is inextricably tied to the stock price locating aberrations in the warrant versus stock price relationship is an excellent means of identifying mispriced warrants. That may happen because warrants are influenced by different supply and demand factors than the common stock. For example, certain institutions cannot or will not hold warrant positions. Nevertheless, they may aquire a position unintentionally as would be the case if the stock they own declares a warrant dividend. The disposal of these warrants sometimes causes tremendous selling pressure not reflected in the price of the common stock. An alert investor can capitalize on these situations.
In theory, warrants should trade somewhere between the two extremes of minimum and maximum value. When the stock is zero the warrant is worthless. As the stock increases in value so does the option to buy the stock. In addition, the warrant assumes a speculative value over and above its intrinsic value known as “premium”. The maximum premium occurs when the stock price equals the exercise price. For higher stock prices the warrant price will continue to increase, but the premium will diminish reaching zero when the common stock sells at about three to five times the exercise price.

Warrant vs Call Option

Let’s assume you want to purchase a house which the owner is willing to sell for $100,000. You want more time before making a final decision so you ask the owner to grant you an option to buy the house for $100,000 for one month. The owner agrees and grants you the option obligating himself to sell his house but asks $1,000 for his obligation. For the next month you are the owner of a Call option. If you decide to go ahead with the purchase of the house, its owner will sell it for $101,000. If not, the owner pockets $1,000 and you lose $1,000. If the price of the house went up rapidly to say $105,000 you can sell your option to another investor for $5,000 ($105,000 market price of the house -$100,000 exercise price). In this case, you’d make $4,000 or 400% on your investment.
The attractiveness of warrants for speculation is self-evident. They are highly leveraged and often marginable. They are available for many less-than-blue-chip stocks, exactly those issues which have the greatest likelihood of making major moves. Speculators will not generally find listed options on these stocks, and warrants are an ideal substitute. The leverage which a warrant possesses permits spectacular gains when the underlying stock makes a major move. This is the main difference between warrant and option.

One spectacular warrant often referred to in investment literature is that of the R.K.O. Company. In the four-year period between 1942 and 1946 the stock advanced form a low of 2.5 to a high of 28. At the same time, the R.K.O. warrants advanced from 1/16 (6 1/4c) to 13. A $500 investment in the stock would have grown to $5,600. The same $500 invested in the warrants would have grown to $104,000.

Warrant hedging

Locating undervalued warrants is not necessarily the complete answer to an investment problem. Warrants are volatile securities, and the risk in establishing positions (either long or short) is extremely high – usually higher than most investors are willing to assume. The risk can be modified by combining the warrants position with an offsetting position in a related security. Such a combination is a called a hedge, and there are two primary types: the convertible hedge and the reverse hedge. Reverse hedges strategy was explained here.

Convertible hedges
This strategy involves the purchase of undervalued warrants combined with the sale of options, stock, or other related securities. The objective is to capitalize on a mispriced security while maintaining control of risk with the short position. Grossly undervalued warrants (20% +) do not occur frequently, but they are available with sufficient regularity so that the list is worth monitoring continually.
In its classic form the warrant convertible hedge is constructed using common stock for a short position. However if an option are available for the underlying common stock, the hedge outcome may be superior if Calls are sold rather than the stock.
To illustrate a convertible hedge the Warner Communications warrants have been selected. The Warner Communications warrants were issued in January 1981 and trading was begun immediately on the American Stock Exchange. In the early months of 1981 the stock advanced sharply but the warrant did not appreciate proportionately. At that time the recommended strategy was to purchase the warrant or, because its volatility was probably unacceptable to most investors, to hedge long positions with stock or Call options. The opportunity to close the hedge came within a month.

In January 1981 Warner Communications common stock traded above $40 and the warrant above $15, which was above its normal value curve. In late February 1981 the common dropped to $34, a decline of 15%. At the same time the warrant dropped to $8, a decline of nearly 47%. The warrant traded considerably below its normal value curve. This was the signal to implement a convertible hedge. Table below shows profit profile calculations for a warrant position hedged with common stock sold short. The short position, 300 shares of common, was selected through trial and error until the hedge outcome produced a favorable risk/reward tradeoff. In this configuration the bottom line shows that, even after commissions, the hedge had much of the potential of the stock at a fraction of exposure to loss. By March 1981 the warrant had returned to its normal value curve and the hedge was liquidated. The stock moved from 34 to 43 and the warrant advanced from 8 to 14. The outcome was essentially as predicted, a return exceeding 30 percent after commissions on a position entailing minimal risk.

Position:
Buy 1,000 WCI warrants at 8,00 = $8,000
Sell short 300 WCI common at 34.00 = 10.200
Commissions = 415
Net Investment = $8,415
Risk/Reward Analysis (assuming 6-month holding period)

Stock price change

-25%

0

+25%

50,00%

Stock price

25 1/2

34

42 1/2

51

Estimated warrant price

6 1/2

8

14 1/2

19

Profit (loss) warrant

(1.750)

0

6,500

11,000

Profit (loss) stock

2,550

0

(2,550)

(5,100)

Dividends paid

(102)

(102)

(102)

(102)

Commissions

(708)

(850)

(950)

(1.035)

Net Profit

(82)

(952)

2,898

4,763

Percent return for 6 months

-1.0%

-11.3%

+34.4%

+ 56.6%

No formulas have been derived to determine how much stock or how many options should be sold short in conjunction with a given warrant position. Selecting the long/short ratio is basically an interactive process The outcomes for various ratios are examined until an acceptable profit profile is obtained. The short position is increased until the investor is satisfied with the downside protection received in exchange for the upside potential sacrificed.




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