Shorting Warrants…Cool, Don’t Do It!

Should you ever short warrants? The short answer (get it, the short answer) is NO. It’s simply a way to turn a safe trade, shorting common and being long warrants, into a nightmare.

Let’s start with this. CAN you short warrants and make money? Yes, and here’s how.

First, the warrant has to be shortable. Most warrants are not shortable (or borrowable) because they have a small float, lack trading activity, etc. Check with your broker to determine whether the warrant you’re interested in is shortable.

Second, find a call option with a strike similar to the warrant and an expiration date close to the warrant expiration. If the warrant is trading at a premium to the call option, short the warrant and buy the call option.

As time passes the premium will reduce more in the warrant than the call option, and you’ll capture the premium you are short.

Now, here’s why I never do it, even if there is money to be made.

A warrant’s terms are set by the company, not the exchange. So, while you know the terms of an option will never change — if it’s a $10 strike call option it will be a $10 strike call option until it expires — the terms of a warrant can, and do, change. I’ve seen it happen on numerous occasions, and it’s not pretty if you’re short warrants.

Let’s look at an example.

Assume a company decides they want their warrants exercised and out of the way (maybe they are going to issue more stock, do a merger, change their capital structure…it can be any reason). Assume the stock is trading at $10 at the time.

The warrants have a strike of $15 and are trading at $1. They are set to expire in six months. If the stock is still under $15 in six months the warrants will expire worthless, and the company will get no money because no one will exercise them.

Let’s short the warrants at $1 and purchase a call option with a similar profile but which is trading at only $.50. (We’ll use a $15 strike call option expiring six months out.) This gives us the opportunity to make $.50, if we hold through expiration and both the warrants and call option expire worthless.

The company announces that the warrants, which previously had a strike of $15, will now have a strike of $5 and will expire in one month.

What happens?

The stock likely drops due to increased arbitrage pressure, say to $9, and the warrants move to $4. As a result, we lose $3 on the warrant we are short, and the call we are long probably drops to $.25, or lower.

That’s a $3.25 loss on a position we would have ideally made $.50 maximum on. Not the best risk reward ratio. It only takes one or two of these to wipe out some very nice low risk gains made shorting common and being long warrants.

What may look like a safe arbitrage trade is actually a very risky trade. That’s why I never do it, even if the warrants happen to be shortable.

Now, some people think this can’t happen because a company can’t change the warrant terms. Wrong.

When a company changes the warrant terms in the manner described above, everybody wins…the company gets an influx of capital, the drag of the warrants is removed from the balance sheet, and the warrant holders are ecstatic.

Wait, but what about the poor guy who is short the warrants, he has some redress, right? I believe it was a situation similar to this where the saying, when pigs fly, was actually invented.

Don’t get caught in this upside-down trade!

To learn how to limit your risk and grow your money with warrants check out my eBook.