Opportunity in TARP Warrants
I'm not an expert on options and warrants, but I believe there's a great opportunity right now in TARP warrants. I'm not very bullish on the underlying shares, but it looks like the warrants themselves are very cheap. Warrants are basically call options, which are contracts that give you the right to buy the stock at any time at the "strike price." The TARP warrants were given by the banks to the government as part of their cost for TARP. They have been auctioned and are now being traded on the NYSE.
There are warrants for many banks. For example, here are two TARP warrants: COF-WT and JPM-WT. These are Capital One and JPMorgan's. They may be under different tickers depending on your broker - Scottrade has them as COF/WS and JPM/WS.
The reasons I find the warrants attractive are their duration and prices. They expire in October 2018. That's eight and a half years! A lot can happen in eight and half years, so you would expect the warrants to be expensive, but I believe the opposite is true. Here are the stats:
Expire: October 2018
Warrant price: $19.68
COF stock price: $46.73
Expire: October 2018
Warrant price: $15.58
JPM stock price: $44.94
For reference, the normal call options that expire in Jan 2012 with strike prices of 45 are $10.50 and $7.25 for COF and JPM respectively. In other words, they have 1/5 the duration and $2-3 higher strike prices, and are only selling for 1/2 as much as the warrants. Clearly, the warrants are underpriced relative to the normal options. There is probably some arbitrage opportunity here, but I don't know enough about option theory to say.
If in Oct 2018, COF sold at $61.81 and JPM sold at $58, you would break even with the warrants. This is about 3% appreciation per year for both stocks, which is a very low hurdle and should be easy to beat if we don't encounter another financial crisis.
Obviously the outlook on these stocks vary greatly, but if you wanted to price these options and knew nothing about the stocks, you can still give a "base case" at how much they might appreciate. Assume they are currently trading at fair value, and will appreciate 8-10% a year, since that is about how much the market returns on average. If this played out, these options would triple in 8.5 years.
As for the upside, it's pretty nice. Financial stocks are still seen as risky, and because of that, they are not too expensive relative to book value and potential earnings. COF is trading under book, and JPM only slightly above. In a somewhat conservative upside scenario, JPM might increase book by 10% per year and trade at 1.5 times book, resulting in a $140 stock price, and a 500% gain for our warrants. For those bullish on financial stocks, further upside is not unreasonable.
So in conclusion, I think these warrants are a good buy at the current prices. I did not have much financial exposure in my portfolio and I think these fill that void nicely. Although I am not very bullish on financial stocks, I don't think it's inconcievable that they might recover to previous levels in time. And although the values of the underlying stocks are debatable, it was clear to me that the warrants were cheap. As with any cheap security, you get disproportionally more upside exposure and less downside risk.
To give credit where it's due, I got this idea from another CAPS player, mikotian. Also, there were a few other posts about TARP warrants, but they did not get as much attention as I thought they should have.
Disclosure: I own both COF-WT and JPM-WT.