Author Topic: Ask Packer - No Seriously, Ask Him Anything (AHA)!  (Read 290489 times)

theantilibrary

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Re: Ask Packer - No Seriously, Ask Him Anything (AHA)!
« Reply #390 on: July 10, 2015, 07:10:17 PM »
I feel a little stupid asking what I'm afraid is probably a very basic question, but how does one accurately assess whether an option is mispriced in relation to the underlying security? This idea of a "compound mispricing" is very attractive, but I have to admit that I have almost no experience with options/derivates and therefore I don't know how to assess whether a given option is mispriced relative to the underlying security. Packer's examples in the prior post such as instances of high demand for short sales or cheap puts when people are super optimistic (the Nikkei example) make sense for getting a general idea of when certain derivatives may be undervalued, but is there a more rigorous way to determine the extent of over or underpricing? I'm not familiar with the calculations that might be involved.

To create an example, if I think that GM common stock is undervalued, how would I go about determining whether certain call options are possibly undervalued even more in relation to the common? (And yes I'm aware of the A, B, and C warrants... I was just using GM call options as an example because I currently think the common looks quite inexpensive). Looking at prices earlier today I saw that the Jan 2016 42 strike calls were trading at the same price as the 40 strike calls with the same expiration date, so clearly the 40s were undervalued compared to the 42s, but how would I know whether paying $0.15 for either is relatively cheap in comparison with the common? (This is just an example, I have no particular thoughts on this option in particular). Does anyone have a good method of calculating relative under/overvaluation of options in relation to their underlying securities?



Packer16

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Re: Ask Packer - No Seriously, Ask Him Anything (AHA)!
« Reply #391 on: July 10, 2015, 07:31:21 PM »
There are two ways to judge the value of an option.  First, you can compare its implied volatility to the historical volatility.  If the implied is less and there is no obvious reason for this decline in volatility going forward is one way.  The other is to calculate an intrinsic value of an option assuming a fair value stock price and compare upside potential.  See attached spreadsheet.  Using this method you can compare relative upside versus the common as a "cheapness" metric.  You track this metric over time to see if relative upside is high or low.

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theantilibrary

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Re: Ask Packer - No Seriously, Ask Him Anything (AHA)!
« Reply #392 on: July 11, 2015, 10:28:59 AM »
Thanks Packer, very much appreciated.

Fowci

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Re: Ask Packer - No Seriously, Ask Him Anything (AHA)!
« Reply #393 on: July 11, 2015, 01:13:09 PM »
There are two ways to judge the value of an option.  First, you can compare its implied volatility to the historical volatility.  If the implied is less and there is no obvious reason for this decline in volatility going forward is one way.  The other is to calculate an intrinsic value of an option assuming a fair value stock price and compare upside potential.  See attached spreadsheet.  Using this method you can compare relative upside versus the common as a "cheapness" metric.  You track this metric over time to see if relative upside is high or low.

Packer

This is a great spreadsheet. But as far as I can tell, you are using call option formulae to value warrants? This overstates the value of warrants because it doesn't account for dilution (that if it's ITM, those who exercise give money to the company and receive shares and so everyone is diluted).  Depending on number of warrants this can be negligible (more warrants = more important) but I thought I'd raise it because I spent a week toiling in excel to come up with a working formula to price warrants.

Packer16

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Re: Ask Packer - No Seriously, Ask Him Anything (AHA)!
« Reply #394 on: July 11, 2015, 01:21:52 PM »
You are correct.  If the dilution is less than 10 percent the effects are small.  I can post a warrant with dilution model next that I have at work.

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Fowci

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Re: Ask Packer - No Seriously, Ask Him Anything (AHA)!
« Reply #395 on: July 11, 2015, 01:31:03 PM »
You are correct.  If the dilution is less than 10 percent the effects are small.  I can post a warrant with dilution model next that I have at work.

Packer

No problem - just letting you know in case you weren't aware of the issue. I built an ugly spreadsheet with iterative calculations to price warrants and I was banging my head against a wall for a few days.

Hielko

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Re: Ask Packer - No Seriously, Ask Him Anything (AHA)!
« Reply #396 on: July 12, 2015, 11:49:04 AM »
I wonder how you would do that since the current stock price should also incorporate the possible dilutive effect of the warrants. So you would have to value the warrants without knowing the "true" current stock price, or you would have to value the stock without knowing the value of the warrants. Seems like a tough problem.

Packer16

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Re: Ask Packer - No Seriously, Ask Him Anything (AHA)!
« Reply #397 on: July 12, 2015, 11:56:52 AM »
It is easier if you have an estimated equity value that is distributed across the securities (warrants and common stock).  A closed form solution has been derived assuming a current stock price.  The formula is iterative as value of the warrant is dependent upon a stock price and probable dilution, based upon expected dilution at expiration.

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Fowci

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Re: Ask Packer - No Seriously, Ask Him Anything (AHA)!
« Reply #398 on: July 12, 2015, 02:09:08 PM »
I wonder how you would do that since the current stock price should also incorporate the possible dilutive effect of the warrants. So you would have to value the warrants without knowing the "true" current stock price, or you would have to value the stock without knowing the value of the warrants. Seems like a tough problem.

You need to enable iterative calculations in excel (under options/formulas).

The two papers I found most useful were:

http://www.fintools.com/wp-content/uploads/2012/02/WarrantsValuations.pdf
(Specifically, the "Galai-Schneller Model with dividend yield" on page 2. This is how I built the BSM modified model)

http://www.pwc.com/en_US/us/audit-assurance-services/valuation/publications/assets/pwc-valuing-warrants-dilution-downround-protection-dwight-grant.pdf
(I found the section "Plain Vanilla Warrants and Dilution" good for intuition and some details about why you should use volatility of the company, not the stock price once warrants are issued).

This is also useful as a walkthrough (at the end) of how the iterative process works.
http://faculty.darden.virginia.edu/conroyb/derivatives/warrants.pdf

CEFs the are trading at a discount sometimes buy back shares and issue warrants at the same time so they don't disappear. You're often trading against retail investors when this happens, so can have a bit of an advantage if you know how the warrants should be priced.

Packer16

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Re: Ask Packer - No Seriously, Ask Him Anything (AHA)!
« Reply #399 on: July 21, 2015, 05:51:33 PM »
I personally never had this happen to me.  One factor you can look for a large stake by a strategic investor or they are on the board.  This can protect your interest.  NTLS has this dynamic.  The largest holder is also CoB.

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