When Warrants Break The Rules

I recently received a great question about warrants from a subscriber for our most recent Strategic Trader quarterly Zoom call. So in today’s Strategic Edge, I’m going to cover that question.

Subscriber Don G. asked:

“Do warrant prices follow a predictable relationship with their underlying stocks prices when there is a broad decline of 15% to 20% in the stock market? Alternatively, is there no established pattern in these circumstances?”

Now, if you’re still unfamiliar with warrants, the basics of how they work are pretty simple. Although they trade like a regular stock, they give you leverage to the underlying stock they represent. So if a stock moves from $10 per share to $15 per share – a 50% move – I would expect that if it has a warrant, the warrant would have a greater gain. Usually 100% or more in this case.

That’s not a hard rule. It doesn’t always work that way. But it’s a decent expectation based on my experience.

That said, you would expect that if there’s a broad decline in the overall market, you would see a predictable relationship where most stocks would sell off.

So if a stock moves down with the overall market, you would expect its warrant to follow.

That may be the case most of the time. But it’s not that simple.

First, there’s a distinction between the move of the overall market and a stock. Yes, in most cases, you can expect that most stocks will follow the general market. And if we have a deep move of 15% or 20% to the downside, it means risk is off. So investors will tend to sell anything not nailed down. Regardless of whether that company is doing well or not.

But that’s not always the case. So when it comes to the warrants I recommend in Strategic Trader, I’m not so much focused on the overall market. It’s more of what is going on with that individual company and the expectations of that company’s business or market sector.

Here’s the prefect example.

2022 was a tough year for stocks in general. The market was down about 20% that year as measured by the S&P 500.

It was rough for most investors.

But that year also handed my subscribers some solid gains if you knew where to look.

Leading into that year, I looked around the landscape for companies with warrants that could potentially benefit from the oil patch. The reason was simple: the crash in the price of oil during the pandemic wasn’t the end of oil. It was just a temporary pause in the world’s most important commodity.

So I recommended two different trades to take advantage. One was in offshore drilling company Noble Corp (NE). The other was in a little-known oil services business Target Hospitality (TH).

The reason for recommending both companies was simple. A recovery in the oil patch would help these businesses recover. Buying their warrants gave readers cheap exposure to that trend and a leveraged bet on the underlying company.

That all proved to be true. And while the overall market sold off, the Noble and Target Hospitality warrants took off.

In May of 2022 – eight months after recommending them – I told readers to sell the Noble Corp. warrants, booking a gain of 130% in the process. That’s compared to just an 18% gain in the stock.

And two months later, I told readers to take a Free Ride on the Target Hospitality warrants for a 532% gain. (A Free Ride is a way to manage risk with speculative trades like warrants. It’s when you sell enough of a position after it doubles or more to recover your initial investment.)

Six months after that Free Ride, we fully cashed out of the Target Hospitality warrants with a 2,174% gain. Almost 23-times the original bet all while the overall market sold off.

Meanwhile, Target Hospitality stock only gained 394% over the same period.

Now, that doesn’t mean we got them all right. We did have some losses in other positions that year. Including in companies that moved with the overall market.

But the point is that warrants – and the stocks they represent – don’t always tend to follow the same path as the general market. (And the winners can more than make up for any losers with proper discipline.)

Apart from that, there are situations where the warrants diverge from the stock as well. Meaning they don’t necessarily follow what happens with either the stock or general market.

When a company issues warrants, it also has an agreement that says what it can and can’t do with the warrants. Sometimes that means the company can “call in” the warrants early. Like if the stock trades above a specific price per share for a period of days. In that case, the company can notify warrant holders it is retiring the warrants.

That usually starts a 30-day clock where you would have to sell or exercise your warrants. Otherwise, they will expire worthless.

In other cases, a company can make adjustments to its warrants depending on what its warrant agreement says.

At the end of 2022, I recommended warrants in Granite Ridge Resources (GRNT). It was another play on the recovery in the oil patch.

Granite Ridge is a unique type of exploration & production (E&P) company. It doesn’t operate any of its wells. Instead, it buys working interests in specific wells with partners like ExxonMobil, Chevron, Marathon Oil and Conoco Philips.

The warrants initially drifted lower after the recommendation. So did the stock. At one point, we were down about 30% on the trade in just a few months. Until this happened…

Within six months, the warrants were up about 90% and we exited the trade. Yet the stock was actually down about 29%.

Why the divergence? It all had to do with a decision the company made with the warrants.

Granite Ridge made an offer to warrant holders. It offered them a chance to exchange each warrant for 0.25 shares of stock. So anyone who had 100 warrants had the right to receive 25 shares of stock.

That effectively made the warrants far more valuable.

Initially, you could exchange each warrant for one share of stock at a price of $11.50 per share. (Meaning you would pay cash to the company to convert the warrants to shares.) When I recommended the warrants, shares were trading for about $9.50. So the warrants were “out of the money” meaning it didn’t make sense to pay $11.50 to convert them to shares.

By the time the company made the cashless exchange offer, shares were trading at about $6 each. That meant the company valued each warrant at $1.50 while they were trading at just over 50 cents each. So the market quickly adjusted the price to account for that difference.

It was a similar situation with Spectral AI (MDAI). Spectral is using AI to help better diagnose and treat burn victims. Its DeepView system’s current accuracy for burn wounds is 92% for adults and 88% for pediatrics. That blows away the 60%-75% accuracy of the experts.

So I recommended the warrants as both an AI play and while the company awaited FDA approval for DeepView.

For the most part, the trade was uneventful. We had a slight gain of only about 8% after 11 months...until things took a dramatic turn.

That’s when the company announced a major change to the warrants. It decided to lower the strike price – the price per share that you can exchange the warrants – from $11.50 per share to $2.75 per share.

It was a huge advantage for existing warrant holders.

The lower strike price meant the warrants were much closer to the stock price at the time. That also meant they were more valuable to speculators than the day before.

Again, the warrants repriced and saw a huge 146% spike in one day. 

And what did the stock do over that same time frame? It actually fell 28%.

The spike in the warrants let us make the easy decision to take a Free Ride on the position. (We still hold the remaining position in the Strategic Trader portfolio that’s showing a gain of more than 300%.)

So getting back to Don’s questions, it’s not as straightforward as it may seem. Yes, warrants can follow the typical path of the overall market or the underlying stock. At the same time, they can also exhibit a pattern that doesn’t do that.

I’ve seen it all when it comes to warrants. I’ve seen them move fast and furious not long after recommending them, like Osisko Gold Group, which handed us a 1,150% gain in a matter of weeks.

I’ve seen them slowly drift lower with the overall market and underlying stock, like Blink Charging, which had us down a little over 80% after a year…Until exploding higher, recovering that initial loss and going on to hand us a 2,805% win.

And as I showed you, I’ve seen the price of warrants diverge from the stock. That’s given us solid gains multiple times even with the underlying stock being down.

Nothing surprises me at this point with how warrants can behave. They’re some of the most explosive securities out there.

But with great risk management and some patience, I don’t believe there’s any better way to speculate in the markets today. 

Regards,

Editor, Strategic Trader