Liberty Broadband rights: Don’t trade deep-in-the-money derivatives

Liberty Broadband is issuing warrants in its rights offering.  Personally, I would be very careful/hesitant about trading those rights.  There is an arbitrage between the rights and the common stock.  This is the kind of arbitrage that high frequency trading is really good at exploiting.  Suppose that the common stock moves 30 cents in less than a second.  Any limit orders for the rights might be trading at the old price 30 cents away.  Somewhere in that time window, it is possible for somebody with a very fast trading system to calculate the correct value of the rights (which is a deep-in-the-money warrant) and pick off any old orders trading based off of slower quotes.  If very few investors trade that particular deep-in-the-money derivatives, there will be adverse selection.  If your order fills, you will likely be trading with a market maker or HFT who is ripping you off.  For good order execution on derivatives, you want to be trading with other investors and not HFTs.

My rule of thumb is to never trade deep-in-the-money options/warrants.  The way I would avoid being on the wrong side of the arbitrage is to trade the common shares instead of the rights.

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(KMI) Mispriced long-term options

Here’s the idea:

1. Find options or warrants where the implied volatility (according to the Black-Scholes model) is very low.  I consider implied volatilities slightly above the IV of the S&P 500 index to be low.  Anything under 30 is low.
2. Among that universe of long-term options, find the ones with underlying businesses that are able to compound their intrinsic value at very high rates.

Compounding is very powerful over long periods of time.  Options are generally a leveraged way of playing a stock.  If a stock is mispriced, the options may be even more mispriced.

Using options

A previous post covered the valuation of options.  Now let’s look at investment/speculation opportunities in the options markets.

Reading financial statements: options

When reading financial statements, it is worth checking to see if stock-based compensation is being expensed properly.  Here’s how.

Usually they will use the Black-Scholes model to value options and they will state the expected volatility figure.  Compare that number with the historical volatility of the stock.  One easy way to get historical volatility information is to look at the Morningstar Options website (here is the page for Berkshire Hathaway).

Valuing stock options

(This may be an advanced topic.)

Most of the time, the Black-Scholes model will come very close to the “correct” price of an option (whatever it is).  Fundamentally, how the Black-Scholes model works is this: