Current Price: $34.52 (warrant price + exercise price)
Estimated Return: $43.65
Exercise Date: 6th of July, 2020
This idea was shared by Tom.
Over the past week, many investors have focused on the performance of Nikola Corporation (NKLA). However, for arbitrageurs the real opportunity is in Nikola Corporation’s warrants (NKLAW). During most of the past week, NKLAW has traded between $30 - $40/warrant below its intrinsic value relative to the common stock price. This offers an attractive capital structure arbitrage opportunity.
Nikola Corp recently became a public company through its acquisition by a SPAC. Nikola effectively inherited the capital structure of the SPAC. SPACs are initially listed as units consisting of shares and warrants. The shares and warrants ultimately trade separately.
The terms of the Nikola warrant are relatively straightforward. It is a 5-year warrant. Each warrant can be exercised into a share of NKLA at an exercise price of $11.50. They can be exercised beginning 30 days from the completion of the merger (June 3, 2020) resulting in a first date of exercise of the 6th of July (3rd, 4th and 5th of July are non business days). They are also subject to a “forced exercise” by the company, if NKLA share price remains above $18/share for 20 out of 30 trading days. The notice period for redemption by the company (i.e., the “forced exercise”) is at least 30 days. Once notice is provided, the holders are essentially forced to exercise their warrants or have their shares redeemed (which is a less attractive financial outcome). The warrant terms are specifically detailed in the Warrant Agreement. The terms are also clearly explained on Nikola’s website on the investor relations FAQ section.
On the 12th of June (Friday) NKLA closed at a price of $64/share. NKLAW closed at a price of $23.02/warrant. Given the strike price of $11.50, NKLAW closed at a price almost $30 below its intrinsic value.
The price discrepancy between NKLA and NKLAW is extremely unusual. Why does it exist? In part it exists for rational reasons that impact the hedging/transaction costs. However, taking these costs into account results in a significant arbitrage spread. There are several ways to hedge the warrants value (with different risks associated with each hedge):
Shorting NKLA. When presented with the above prices and terms most readers will immediately think, “buy the warrant and short the stock”. That was my first instinct. However, NKLA borrow is difficult to obtain. I was offered borrow at 175%/year fee when I first began investing in this position, but that borrow was available to me for about an hour on Tuesday morning and I have not been able to obtain any borrow since then. Assuming that an investor is able to obtain stock borrow at a rate of 175%/year, the expected cost of borrowing NKLA until exercise would be approximately $10/share. The resulting profit from the trade would be equal to the price at which the investor shorts NKLA less the cost of borrowing the shares less the strike price less the warrant price. Using the closing values from the 12th of June would result in a profit of $19.5 (for purchasing a warrant for $23/warrant, shorting a stock at $64/share and holding the position for less than a month). Translating the $19.5 profit into a measurement of return on capital depends upon how an individual investor measures the capital of this type of trade. The $19 profit is equivalent to a return of approximately 85% on the value of the asset purchased (in less than a month). The primary risk of this trade are that the investor may lose their short borrow or the borrow rate may increase.
Synthetic short through options. If an investor is not able to locate NKLA shares to borrow and short or is uncomfortable with the risk of losing the borrow or the cost of borrow changing adversely the value of the warrants can also be hedged via a synthetic short created by the purchase of a put and the sale of a call with identical strikes. The price of the synthetic short is the Strike Price less the Put Price plus the Call Price. I have created synthetic shorts using the July 17 maturing options. Although there are July 10 maturing options I wanted to make sure that the time period between the option exercise (the 6th of July) and the option maturity (the 17th of July) was sufficient to settle the shares obtained via the warrant exercise. Last Friday the July 17 $50 strike Put option closed at $20.35 and the same strike Call option closed at $14.00. Thus the using the 50 strike options results in a synthetic short price of $43.65. The trade would result in a profit of $9.13. This profit is significantly less than the profit from simply shorting stock against the warrant, but it still provides a very high return for a low risk trade. I believe this trade has two primary risks:
- Account Equity and Margin Requirements – from an economic perspective the short calls are covered by the warrant. Unfortunately, in standard margin accounts, brokers will not consider this economic coverage and will treat the short calls as naked. Thus, if the calls increase in value, the holder will be required to fund the losses on the short calls and increase the margin held against the positions. It is likely that the warrants will be required to be paid for in full. As a result, from a margin perspective gains in the warrant will not offset losses from the short calls.
- Early Exercise of Short Call – the high cost of borrow makes it relatively more attractive for holders of calls to exercise early. The long call holder will exercise prior to maturity if the interest they could earn by owning the shares and lending them out exceeds the cost of financing the shares and the difference between the option price and its intrinsic value. Depending upon borrow rates, this will be the case for deep-in-the-money short maturity call.
Both of these risks can be mitigated by using higher strike options to create the synthetic short. However, as the strikes get higher the synthetic short tends to fall.
Related points of interest
Why have I assumed that investors will exercise the warrants as opposed to selling them?
- I don’t expect the warrants to trade significantly above their intrinsic value because of Nikola’s redemption rights. Many factors will influence the timing of Nikola’s decision to provide investors with redemption notices. However, I expect investors to assume that redemption notices will be provided as soon as possible. After all, the dilution from the warrants is inevitable. Why shouldn’t Nikola get the $11.50 in cash as soon as possible? In any case, given how high the stock is trading above the strike price there will be little “option value” in the warrants. I do believe that once we reach the first exercise date the warrants will trade at their intrinsic value (the difference between NKLA price per share and $11.50) unlike the current situation.
Why don’t long NKLA investors simply replace their long positions in the stock with long positions in NKLAW?
- Why buy NKLA for $64/share when you can buy an instrument that is convertible into NKLA for $34.52/share ($23.02 to buy NKLAW plus $11.50 to exercise the warrant)? An investor that buys the warrant has exactly the same upside as one that buys NKLA, but can only loss $23. The only investors that I can think of that would not buy NKLAW instead of NKLA are: 1) uninformed investors that aren’t aware the warrants exist, and 2) investors that trade at firms that restrict investors from trading warrants. I hadn’t really considered this second possibility, but then I found a firm that does not allow its clients to purchase warrants. Guess which one? Robinhood! Robinhood does not allow investors to purchase warrants. Their explanation appears to be that too many investors inadvertently traded warrants instead of common shares by putting in the wrong stock symbol (eg, adding a W to NKLA and buying NKLAW, which would be a really fortunate mistake to make). Since clients of Robinhood are thought to be relatively active investors in NKLA this point is quite interesting.