Unorthodox SPAC Pseudo-Arbitrage Opportunity
[Hey guys, a special treat today. One of our Warrant Observer members, Theo, (disregard the “by Steven Adams” at the bottom) has come up with an idea on a SPAC ETF. As always, nothing in the blog post is a recommendation to buy or sell any security, option, warrant, etc. The ideas here are for educational purposes only. The author, may or may not hold a position at any time in this trade.]
Hello! Today i’ve got an interesting idea to share – I’m going to preface this with a few points, but note that this is a “low risk, low reward” idea with very skewed odds. The idea is a pseudo-arbitrage idea on the active SPAC ETF – NYSE: SPCX.
In summary, this is a new ETF that is conservatively run. It buys units near $10 on issuance, and sells them once they get to levels above $11-$12 or splits the units. The ETF is highly diversified, with 90 holdings of around ~2% positions. You can learn more about the ETF here – https://www.spcxetf.com/.
The ETF has risen consistently from an IPO trust value of ~$25 per share to $29 today, by slowly selling down positions like CCIV that have been caught in general SPAC market updrafts. It’s interesting altogether as an investment position alone, due to those characteristics.
The Trade
So, onto the idea, which specifically stems from the miscalculations of Black-Scholes for SPACs. Black-Scholes is an options pricing model used to price options based on their implied volatilities (standard deviations), which are typically based on estimates or historical data.
In this case, though, SPACs shouldn’t go below a certain “floor”. This caps the losses at somewhere around trust value. Thus, the market is mispricing these options significantly, and there are few institutional arbitrageurs in the warrant / SPAC market (or they are just getting established).
However, it’s worth keeping in mind that SPACs can and do trade at discounts to trust, although very rarely do units do (implying that warrants are worthless). In some cases, they can trade in the ballpark of $9.5 – $10, but this is quite rare due to the upside “optionality” present in SPACs as well as the warrants.
Current Trust Value
So what is the trust value – you may ask? Well, thankfully someone on reddit posted a google sheet calculating the value of the ETF if all of the units / commons owned traded down to a floor of $10.
I’ve linked the google sheet below, but the TLDR is that the “floor” per ETF share owned is about $27.8. Factor in another 3% discount to be conservative in the case of volatility, that leaves us with a floor of around $27.
Finally, the core trade is selling the $26, $27, or $28 puts for December 17th. At prevailing market prices, this equates to a 9.2% cash on cash return if the aggregate basket of SPAC units doesn’t trade below trust value. If it does, then the put options will be exercised and you can own SPACs at significant discount to trust value.
In fact, the core way to lose here is if the ETF trades below $25.5, at which point the units will trade at an aggregate ~9% discount to trust value (not including the value of the warrants received). Seems pretty crazy right?
Key Benefits
So why bother with this idea over others? Well here’s a few key benefits
- SPAC markets are volatile, especially in warrants – and this allows you to offset some of the “warrant market risk”. You can see that this was especially punishing recently by looking at trends in warrant prices. By placing trades like these, there are enhanced return aspects without the same level of volatility risk (even if you really believe in a team).
Above, you can see how punishing the general SPAC warrant market can be. By having money pooled up in trades like these, you can fund additional warrant purchases or “average down” into other more volatile investments when the opportunity arises.
- These options are MUCH more liquid than individual SPACs – particularly even ones like PSTH. PSTH followers have been executing a similar strategy with selling the put options at or near trust ($20). However, the returns are almost identical (at ~9%). With the added risk of PSTH completing a deal and the downside risk stemming from that. This ETF typically sells the positions well before deal close, and generates consistent proceeds from selling the warrants embedded in the units. Additionally, the increased volume should help a ton if you need to exit the trade. An extremely important aspect given new opportunities may arise if you would like to buy back the puts before expiration.
Risk Profile
So what are the key risks that I see? Well, one is that the actively managed ETF strays away from its general mandates and begins to hold the commons and/or warrants past deal close. Note that the risk of a position going up, and the ETF sponsor not selling it is negligible, since you are selling the puts at the initial value of those positions.
However, this hints at another potential issue – the sponsor may begin to buy overpriced units well above $10. Both of these possibilities seem remote, since ETFs typically don’t make drastic moves in this timeframe and SPCX has been outspoken about sticking closely to their strategy.
Another risk that may arise is that the ETF SPCX “winds down”. Since it is a relatively recent ETF with only ~$150M in AUM, there is a chance that it shuts down before the put options expire. In this case, the assets will likely be redeemed and/or sold on the open market for cash – providing a “locked in” return selling puts below that cash value.
Risk/Reward
So, why do I find this idea interesting enough to share? Well, a 9% return might not sound like too much, but it’s a >11% IRR given we are already well into 2021.
Given the risks mentioned and the difficulty in getting yield in this environment, this would be comparable to a junk bond with very questionable credit quality. I think these puts should be priced at around a 5% IRR instead of a 11% IRR, which highlights the mispricing.
Although, I would be careful with selling put options – you never know what could happen and the risks could be severe. Thus, when placing these trades, I always measure the return based on the cash I have to “lock up” during the entire period in the event of a maximum loss – in this case the strike price.
This strategy without margin or leverage reduces the returns. But, there is a potential for a leveraged strategy with these put options that generates significantly higher returns – 20% IRRs+ that would significantly rival any risky equity investments.
That being said, feel free to ask any questions. The idea is fairly straightforward, and I recommend reviewing all scenarios before writing any options. This one is definitely worth the watch, though.