Yesterday I shared a post relating to how I view arbitrage opportunities using a Concentric Circles Model.

Let’s go a little deeper into that model and talk about some of the important aspects.

Gotta Start with the Basics

I was just listening to a podcast on business building, and the host was hammering away at getting the basics in place before you can move forward.

We don’t talk about it a lot, but you have to have your warrant list in place if you want to be consistently profitable at this game.

I try to help people out with this blog and the Warrant Watchlist, but you have to be actively seeking deals and tracking warrants to find opportunities.

I provide a warrant database to Warrant Observers members as a quick start service to get you up and running. But you have to track that list and stay on top of opportunities to find the first ring in the Concentric Circles Model.

I had an awesome email from a reader who took a warrant I put on the Warrant Watchlist, and did something really cool. HE WATCHED IT!!!

Check this out (and thanks Alex). Look at his returns a month later on MTECW, which I said to keep an eye on a whole month before the shareholder vote to approve this SPAC’s merger. (I mean, what more of a heads up do you need, LOL. It subsequently became KERNW.)

Dude killed it, great job! There’s some extra vacation money.

Now, this is more of a SPAC pattern play, specifically this pattern. But, it all started with tracking to see where to find a good deal.

Start with my database or build your own, but you have to find that first circle in order to even begin using a Concentric Circles Model.

Find the Profitable Circle

For some trades all you’ll need, and maybe all you’ll be able to trade, is the first circle. The warrant and the common stock.

I’ve done this countless times, and when I was first learning arbitrage it was the only thing I did. A snorkel trade, up and down, long warrants and short some percentage of common. Put it on, take it off. Rinse and repeat.

The next layer out, as we talked about in the last post, is options on the common. So your first step here is to see if the common has options, and then to determine how liquid they are.

As I mentioned, I’m doing a nice lazy summer trade in AIG and the AIG warrants using these two circles right now. Long warrants, short common, short calls, and short puts.

But what if you don’t have options available?

Expand your possible circles

Before we go further, you should be aware of one thing. Correlation, beyond the common, warrant, and options, can make you money until it costs you money.

In other words, the further you venture into the concentric circles the larger the circles grow, and the greater the risk you take on.

The easiest way to control this risk is by limiting the size of your position.

Having said that, in expanding our circles, this is where you want to use your imagination.

You can start with a similar search to what you would do in a pairs trade. If you’re trading an insurance company, identify other insurance companies that are similar.

You can then move to the options of the similar company. Perhaps the similar company to your core holding has more volatility, and therefore more premium in its options.

How is your core holding correlated to the industry it’s in? Do the stocks move in lockstep, or not?

Is your core holding correlated to another asset? Does the movement of oil, or gold, or interest rates impact the direction or velocity of your asset?

As you can see there are a lot of possibilities. As long as you remember the further out the circle, the higher the risk, you can take multiple small positions against your core holding.

Concentric Circles with SPAC plays

Another way to employ the Concentric Circle Model is with long SPAC plays.

Let’s go back to MTECW/KERNW for a moment.

With the anticipation of a pop upon the vote to approve the merger, say you wanted to be long MTECW.

But, for whatever reason, you’re afraid a negative news announcement in regard to cannabis legalization might be on the horizon. You could offset your warrant long with either a small short position, or short call position, on another cannabis stock.

This won’t always be the case, but there is generally some way in which to hedge your position with some instrument that is within the concentric circles of your core holding.

Use your position as an asset

Finally, the way you think of your core holding probably needs to change.

Most traders and investors buy and sell stocks with one thought in mind. Tracking the change in price. If I’m long and it goes up, I made money on the change in price. If I’m long and it goes down, I lost money on the change in price.

With arbitrage you need to think differently.

Your position is an asset in itself. This means you should be using that asset to make more money.

The only thing most investors do in this regard is a covered call. That is baby steps compared to what you can do.

Let’s look at a quick example.

Let’s say we’re long 1,000 AIG warrants. We think an 80% hedge is appropriate for where the stock is now. So, we short 500 common shares. We then sell 1 call contract. That gets us to a 60% (ish) hedge.

Maybe we take a look at Metlife (MET) and see it has some good premium in its calls. So we short two calls on MET to get us to our 80% hedge. And there is our position.

Complex Research, Simple Execution

Hang on now. You might be saying, “I thought you said you like to keep it simple. 10 different hedges on one core position is a trainwreck.”

And to that I would say, Amen Brother!

So let’s finish with this.

Look at ALL the possibilities you can think of as the concentric circles move out. This can get pretty complex, like figuring out how to cut the cost of NASA launches.

And then after you’ve gotten it all on the table, execute the simplest trade that makes sense.

In the vast majority of cases you’ll be sticking to the first few circles. Long warrant, short common, short calls, and short puts.

But, in some cases you will have to go beyond the first few circles, eg, no options are trading on the common. Don’t let that stop you from trying to find a profitable trade in the further out circles.

And here’s a BONUS TIP for those of you who’ve stuck with me to the end. As you look at what’s available in your concentric circles, guess what you’ll find? More opportunities!!

I don’t know how many profitable trades I’ve found by starting at one circle I thought would be my main trade, and then finding a better trade about 3 sets of concentric circles later.

And speaking of bonuses, I told you in yesterday’s post I’d be announcing a bonus for new members of the Warrant Observer program that join this week.

I’ve recorded a few hundred videos on options trading, and I’m getting ready to turn the camera back on for a special course that teaches how to use options in arbitrage trading.

This will be a course focused on the various ways you can use options to increase your profits, or in some cases manufacture profits. It can literally mean all the difference between a profitable and unprofitable arbitrage opportunity.

Become an ANNUAL Warrant Observer member this week and you’ll get this absolutely free when it drops in a few weeks. The course will sell for $97 by itself after it’s released. Just a heads up.

The latest newsletter is headed to members this Friday!!