When Very Long Term Warrants Become Very Short Term
While making breakfast this weekend, mmmmm bacon and eggs, with the wife and kids still in bed, I decided to test drive our new Echo Show.
“Alexa, play a stock market podcast”…I asked nicely. (Do you also feel like you should be saying please and thank you to our voice controlled minions?)
Eventually, after a few detours into cooking shows and Nascar news, I got to the Odd Lots podcast. A Bloomberg sponsored market topics podcast.
The podcast started playing, and the bacon started sizzling, and I was happy to find an NPR style podcast with very sane sounding hosts. No CNBC, CNN, MSNBC, or any other cable network, yelling heads.
And, they happened to be talking about derivatives, Yippee.
Yes, sadly for my daughter who happened to arrive for breakfast a few minutes into the podcast, she was subjected to a brief intro to the world of Super Lizards and Double Chance, before she dove head first back into Tik Tok.
These are colorful names for a few of the potentially toxic structured products now being peddled in Korea.
So, if in a few years the U.S. market crashes because of a “Super Lizard”, well, as long as it’s not the actual Godzilla, you heard it here, or from the Odd Lots podcast, first.
All good, until its not
One aspect of these structured products is particularly fascinating, and don’t worry, I’m not going to dive into the underbelly of derivatives here. But it’s the thing that makes them “dangerous”.
It’s also the thing that made me think of Virgin Galactic, and particularly the warrants. (I’m thinking often of Virgin Galactic these days as the warrants are basically now paying my son’s college tuition for the next few years, thank you Sir Richard.)
See, with these Super Lizards, there is what you could call a tipping point. As long as the markets they are based on stay in a range, up or down, the banks who have to hedge them are good, and the investors who expect to get all their money back with a nice return, are also just fine.
But, when the market goes down a certain amount, I believe in the podcast example it was 30%…well, then all heck breaks loose.
It’s like rollerblading on the lip of the Grand Canyon. It’s all good and fun as long as that blade doesn’t move that last inch over the edge. But when it does, splat.
But, even before that final inch is violated, if you’re the rollerblader, you’re probably in a pretty cold sweat as your foot grazes the top edge of the canyon.
Financial instruments are the same way. They “react” to the cliff coming nearer.
And that brings us to the Virgin Galactic warrants.
It’s not as dramatic as the Grand Canyon, but the cliff is quickly approaching for the premium in the warrants.
Long term warrants, just like long term call options, generally have a pretty good premium baked into them. The more volatile the stock, the higher the premium. Just like with any option which is priced relative to time and volatility.
But, SPAC warrants in general these days, and Virgin Galactic was born of a SPAC, often have a warrant call provision. The in vogue thing to do nowadays is to place that call provision at $18.
So, if the common stock closes over $18, for 20 out of 30 trading days, the company has the option to call the warrants.
Goodbye rich premium, we knew you so well
And, what does this proverbial cliff mean for the warrant?
Basically, you’re going from a 5 year warrant with a big fat premium to a 60 dayish warrant with very little premium. You’ll retain some volatility premium, but with the warrant so deep in the money that will be very little as well.
This impacts you if you are long the warrant, and suddenly see the rate of increase in the warrant not keeping pace with the stock.
And, it impacts your strategy if you are doing a classic warrant hedge and are long warrants and short common.
Or, if you are pairing the warrant with an options strategy, such as a calendar spread. The change in character of the warrant can blow up your trade, e.g., the premium in the warrant drops off faster than a closer in call option you’ve sold.
The “cliff” of $18 makes it more difficult to trade the warrant, as the warrant is essentially morphing from a long term instrument to a short term one.
A silver, and possibly solid gold, lining
So, the possible passing of the Virgin Galactic warrants will be mourned by warrant holders everywhere, if and when the stock holds above $18 for 20 days. And believe me, I don’t think it’s an if, just when.
But, as with all great stock (and warrant) stories, this one isn’t quite done. Not just yet.
There is another trade, maybe the biggest one yet, born out of a warrant call that Warrant Observer members will be taking advantage of. (I need to pay some more college tuition bills as my daughter is just a scant few years away from her high school graduation…don’t bring this up with my wife, btw.)
So, while Warrant Observer members bought the warrants just before, and sold into the faux hot IPO at the end of October.
And, then sold any remaining positions as the stock fell through $9, on my “if you have any of these left, I WOULD NOT hold it if it breaks through $9” call.
And, finally reloaded on the warrants as the stock held above $7, to capture massive gains in this one so far (as of today that’s a 320% gain in the warrants vs. 145% in the common stock)…we’ve still got one more trade to come.
If you missed all the others, but want to get in on this next trade with us, you’re always welcome to join our little group here: