TARP Warrant Auctions May Offer Opportunity

Updated to include latest share price, further context.

NEW YORK (TheStreet) -- JPMorgan Chase (JPM) investors might see its share price pop higher now that its TARP warrants auction has closed, according to some derivatives traders.

On Friday, the Treasury Department said it received $936.1 million in a Dutch auction to sell 88.4 million warrants. The securities allow investors to purchase JPMorgan shares at a set date in the future, at a fixed price. JPMorgan's warrants were priced at $10.75 apiece - a significant discount to the $41.27 the stock closed at on Thursday. In recent trading, JPMorgan was down 13 cents at $41.14.

Warrants have played a far less prominent role in bailout proceedings than the Treasury Department's larger preferred stock investments. Traders say banks that opt for auctions - rather than purchasing them directly from the Treasury Department - have been affected by behind-the-scenes trading activity not evident to retail investors. Once auctions are complete, they say, companies with strong financial metrics and reputations will see their share prices pop.

Here's how it works: Some traders have been able to purchase warrants at a relative discount to the shares they currently hold. Therefore, they are using warrants as so-called "stock replacement" securities, which will allow them to obtain shares much more cheaply at a future date. They are also cashing in on the premium of the long positions they currently own, which has held back or pushed down stock prices.

"These are pricing at what we would think to be a fairly decent discount," Tim Freeman, head of U.S. equity derivative sales at Capstone Global Markets, said on Thursday. "So [traders] shift all the exposure into warrants. They'll turn around and sell their common shares and buy the warrant."

Once the auctions are over, long-term investors would go back to buying plain-vanilla stock, moving the price higher again.

For instance, notes Alexander Witten, an equity derivatives trader at Hapoalim Securities, Capital One (COF) shares dropped 7% between the market close before the Treasury Department's auction announcement on Nov. 19 and when the auction was completed early Wednesday. With the auction over, it has regained 3%.

Similarly, JPMorgan's shares fell 4.5% since the auction announcement through Wednesday, the day before bidding closed. The stock started trading higher early Thursday afternoon, and closed up 7%. Some derivatives players predict more positive movement on Friday.

"A lot of the potential warrant buyers are already long shares in JPM and therefore have been selling out of the long stock and will buy the warrants as stock replacement ," says Witten. "...This is because this 'pre-hedging' of the warrant delta is over, and the selling pressure has alleviated. I would expect [JPMorgan] to catch a bid on Friday after the auction is over."

However, the story is not quite so cut and dry, according to Linus Wilson, a finance professor at the University of Louisiana at Lafayette, who has studied TARP warrants extensively. He notes that traders with short positions and call options could continue to put pressure on JPMorgan shares.

"If JP Morgan does not buy a substantial stake in the warrants (or more than is expected), then there is no reason for the stock to rise for technical reasons," he says in an email message. "It may even fall."

TARP warrant auctions have had other ripple effects into the options market as well. The discounted pricing has affected what is known as "implied volatility" on long-dated options whose exercise date is relatively far into the future. The more volatile an option, the more profitable it is for derivatives traders.

However, since Capital One's auction was announced, the implied volatility on Jan. 2012 options has moved down by anywhere from 10 to 13 points. JPMorgan options with the same exercise date have dropped 8 points in implied volatility measures. Witten says this has been the "biggest impact" that the warrants auctions have had.

Witten has been advising clients to be long JPMorgan stock and call options into the results of the auction.

There are 693 banks involved in the capital purchase program that will have to redeem warrants directly from the government. With Bank of America (BAC) yet to extinguish its warrants, and Citigroup (C) and Wells Fargo (WFC) yet to repay TARP, the market for bank derivatives could be rife with opportunity. The ordinary stock market could also provide chances for investors to buy bank stock more cheaply, ahead of a warrant-free climb.

The dip and climb won't necessarily occur with each of the 693 banks that are still participating in the bailout program. Some may pay a premium to redeem warrants outright, as Goldman Sachs (GS) did. And the third bank participating in the Treasury Department's initial Dutch auction, TCF Financial (TCB), has seen its shares climb nearly 7% since the auction was announced.

"It really depends on how big the transaction was and how much linking is going on with the warrants and how people really feel about the entity going forward," says Freeman. "But in JPMorgan specifically, yes. I think the shares do appear weak as a result of the warrant, and should move higher going forward."

-- Written by Lauren Tara LaCapra in New York.

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