Ever since I mentioned my event-driven book last week, I’ve had a bunch of questions on it from readers. I’ve been hesitant to speak much about this ED book as the opportunities tend to be short-term in duration and the overall win-rate often isn’t that good. It’s more about risking something tiny to see what happens, applied across a large number of situations. However, despite a low overall batting average, this book continues to have shockingly good performance—though the results can be volatile. With that out of the way, I’d like to walk you through a typical event-driven opportunity I’m currently involved in.
I own warrants (NKLAW – USA) on Nikola Corp. (NKLA – USA). Before we get into the details, I’d be remiss if I didn’t mention that I believe that Nikola shares are fundamentally worthless, meaning that the warrants are a derivative instrument on something worth zero. In fact, the only people stupid enough to buy Nikola are the sorts of pikers who also buy other worthless automotive stocks like Hertz (HTZ – USA) and Tesla (TSLAQ – USA). Then again, Hertz is already functionally bankrupt and Tesla is a fraud. At least Nikola doesn’t have the legacy baggage of the other two and likely beats Tesla to commercial production of a semi, if Tesla even bothers to produce one.
Remember my new favorite “global micro trend” is massive inflows of capital from brain-dead retail investors. Well, these fools are so hopped up on FOMO, that they’re lifting every share of Nikola without realizing that they can buy Nikola warrants at roughly half of intrinsic value. For a quick primer on the math, on Friday (June 19, 2020), Nikola closed at $66 a share and the warrants closed at $28.50. The warrants let you buy shares of Nikola at $11.50 at any time over the next 5 years. Hence, they should be worth $54.50 ($66 – $11.50 = $54.50) before you even include theoretical time value (which likely has minimal value as the warrants are almost certain to be called in July). Hence the warrants should trade roughly 90% higher at around $54.50.
Now, there’s not supposed to be free money in finance and there are a number of theories going around about why the warrants are so undervalued. To start with, there is no risk-free arbitrage opportunity here. Shorting common, to lock it in, costs you north of 700% annualized to borrow and July 10, $66 strike puts (which capture the warrants becoming convertible on July 6) trade for $25, roughly netting out the arbitrage opportunity ($66 – $25 = $41 – $11.5(strike) = $29.5 or only $1 of spread from intrinsic). My good buddy Kevin Muir (http://themacrotourist.com) posted his own arbitrage trade with options to lock this spread in—his math checks out, but I’m willing to go into this one naked.
Friend: Wait, what…???
Me: Yeah. I own the warrants straight up.
Friend: But this is absolute crap. How can you own it?
Me: Borrow is tight as all hell and the fukwits at Robinhood keep buying. You think they’ll lay off their Ponzi Jihad before the unlock? They don’t even realize there’s an unlock coming.
Friend: But it’s worth zero. Right?
Me: Yep. Absolutely. On July 6, they unlock this sucker and it waterfalls. But a lot can happen before then and I’m coming into this nearly $30 offsides of intrinsic from my cost basis. I’ll take my chances. Besides, I think I found the “glitch” haha…
Look, there are a LOT of ways to get screwed here. In fact, there are so many that I’ve sort of lost track. There’s basis risk, there’s cashless exercise, there’s forced exercise. Hell, the shares underlying the warrants haven’t even been registered (please read the prospectus if you’re going to play along). I’m not saying this is risk-free, in fact, it’s quite risky. But the warrants are priced for the risk and if the SEC declares the recently filed S-1 effective in the 9 trading days between now and the unlock, these warrants will trade up quite close to intrinsic. No matter what, I’m out before the unlock on July 6—this trade purposefully has a short fuse for me. Meanwhile, there’s a not small chance that the shares trade up into the unlock. The insiders clearly need a bid for their stock and they must have a bunch of IR planned over the next two weeks. If the shares rally, that’s just extra upside. Otherwise, any price over $40 on Nikola shares, means the warrants come out ahead compared to Friday’s close and besides, my own basis is a good deal lower. Finally, DraftKings (DKNG – USA) just cashed out their insiders on Friday and the stock actually traded up. That has to put the fear of god into Nikola shorts.
So, that’s how I construct an event-driven opportunity—short fuse, high return, low risk and insanely high IRR when it works. If you can package a few dozen of these into each quarter, keep each position small and keep the book roughly balanced, you’re probably going to come out VERY far ahead as the handful of big winners more than pay for the losers. As per each individual one; who knows? It’s not like I’m actually bullish on Nikola, but neither is anyone else who understands how finance works—hence why so few funds are willing to buy up the warrants naked, despite the massive discount to intrinsic—hence why I think the opportunity exists in the first place….
Anyways, caveat emptor.
Disclosure: Funds that I control are long NKLAW
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