Hedge Fund Series: Ed Thorps Strategy To Beat The Stock Market

Article: ^{https://www.researchgate.net/publication/275756748_Beat_the_Market_A_Scientific_Stock_Market_System}

Stock Warrant: A stock warrant is a financial instrument issued by a company that grants the holder the right, but not the obligation, to buy the company's stock at a predetermined price (strike price) within a specified period. It is often attached to other securities like bonds or preferred stock and can be traded on stock exchanges or over-the-counter markets. Warrants offer potential leverage to investors as they require a lower initial investment compared to buying the underlying stock directly, potentially leading to higher percentage gains. However, if the stock price fails to reach or exceed the strike price before the warrant's expiration, it becomes worthless, resulting in the loss of the initial investment.

Warrant Hedge: Warrants, being derivative securities, can be subject to significant price fluctuations due to changes in the underlying stock's price and other market factors. To protect against potential losses or to reduce exposure to these price movements, investors can employ various warrant hedging techniques.

One common warrant hedging approach is to simultaneously buy or sell the underlying stock in the same proportion as the warrants held. This creates a neutral position, known as a "delta-neutral" hedge. By doing so, any gains or losses on the warrants are offset by corresponding movements in the stock position, helping to mitigate overall risk.

Beat The Market Strategy

The strategy begins by selling short 100 company XYZ warrants while simultaneously buying 100 shares of XYZ common stock. The plan is to close both positions just before the warrant's expiration.

The profit or loss on the investment is calculated based on different possible prices of the common stock on the expiration date. If the common stock is above the exercise price of $10, the warrant will be worth around $10 less than the common stock. For example, if the common stock is at $20 on the expiration date, the warrant will be valued at $10, leading to a $14 profit per share of common stock (20 - 6) and a $7 loss per warrant (10 - 3). The combined investment would yield a net gain of $700.

If the common stock is at or below the exercise price of $10 on the expiration date, the warrant will likely sell for only a few cents, resulting in a profit of about $3 per warrant on the short sale. Additionally, if the common stock is between $6 and $10, there will be a profit of $0 to $4 per share on the common stock. However, if the common stock falls below $6, losses will occur, but as long as it remains above $3, the short-sale profits on warrants will offset these losses, leading to a net profit.

Regardless of how much the common stock rises in the next 18 months, the combination of investments ensures a profit of $300 to $700. The strategy also guarantees a profit unless the common stock falls to half of its present value within 18 months, which is considered unlikely.

This method leverages the price movements of the common stock and the warrants to create a hedge that provides potential profit opportunities while minimizing risks associated with market fluctuations. However, investors should carefully assess the risks and consider market conditions before employing such strategies.