Afterpay (ASX: APT) and the Delta Hedge

Yesterday we had a number of emails and concerned subscribers on Afterpay (ASX: APT). The concern was that it was being attacked by short-sellers. There was an article in the AFR on short-selling APT due to the convertible note. I wrote back as did Marcus on the subject. The stock was down over 3% but the question is, was the short-selling to blame? Easy to blame something like that but I would caution against it. It is no coincidence that the company presented at the Macquarie ‘Omni’ Conference yesterday and we saw tech stocks under pressure in the US. I wrote about Delta Hedging (April 20^th) and how it would affect Z1P when they did a similar convertible note deal post-APT’s one. When a bunch of institutions buy a convertible note that gives them an equity option, there is a price they are paying for that option. Along with that comes the Delta of that option. The Delta is how much an option moves compared to the stock. Let’s make it simple. If the option has a Delta of 0.5 then the option price will move 0.5c for every 1c. In APT say a buyer of the note may have a Delta exposure as they are now long the stock effectively. If I bought 1m notes with a Delta of 0.5, then I would be long the equivalent position of 500,000 shares. The Delta is calculated using a complicated ‘Black and Scholes’ option pricing model which includes interest rates, time and volatility. So, this note buyer then sells at the same time 500,000 shares to be Delta neutral. No overall exposure. That’s what happened in both APT and then the same when Z1P copycatted them. As the price moves up, so does the Delta of the option so the buyer gets longer as the Delta may increase to 0.6. 1 means that it moves cent for cent. As the stock goes higher, the buyer gets longer and so becomes a natural seller into strength if they wish to remain Delta Hedged. If the price falls the Delta falls and the holder of the note gets shorter, and so becomes a natural buyer of stock. Buy Low, Sell High. Perfect. This strategy is called long volatility. As a former derivatives trader, and hedger of these sorts of structured products, it was my bread and butter. The ideal situation is to buy back the short stock position at such a price that the convertible option that you have bought effectively costs nothing, so you just have a call option running for nix. Sometimes you make a profit on one side and you are exposed on the other side for less than nothing.

Newton’s third law though says for every action there is an equal and opposite action.

Someone out there has taken the other side of the trade. They have bought the stock and sold the convertible note. It is a giant Buy Write in some ways. They are now short volatility. Short volatility means that as the price of the underlying falls, their long position gets bigger. The Delta of the Call option falls, so the stock position gets more dominant. So, as it falls, they are a natural seller. More like a panicked seller in some instances. As it rises, they get shorter, so they are chasing it higher to buy and square up exposure. Being short volatility can cause short term volatility. Equally being long volatility can dampen it, as traders sell into rallies and buy dips. In some ways it is a bit like who blinks first? Who has the greater risk appetite? Who is happy to let a position run before re-hedging? In my old derivatives days, we had big risk limits and were prepared to take a view. And it was done manually. Mind you the numbers were smaller. These days I suspect algos trade on defined parameters and dynamically Delta Hedge. If it moves this much, then do this. That sort of thing. No one wants as much risk as they used to. Numbers are too big. Jobsworth numbers. I know there was an article in the AFR about surprise short sellers, but it really is no surprise if you understand options and convertible notes. Apart from the fact that this deal was done some time ago, the article does not really understand that the sellers of the delta hedge would be buying the stock not selling it to remain delta neutral. So, if the Short Sellers were not to blame, then what was? The Nasdaq falls, yes to some extent and maybe the presentation disappointed. I had a brief look through and admittedly I wasn’t there in person, so hard to gauge the tone of the talk, but it did look like a very defensive presentation. A small target presentation. There seemed to be plenty of justification slides. Justifying why they are a force of good not evil. That’s fine but it's not the sizzle that some may have wanted to hear and so voted with their feet. Here is a sample of the slides that ‘concerned’ me. Maybe 'concerned' is the wrong word. Maybe the conference theme was supposed to be skewed this way. Maybe I am reading too much into the slides but did seem a little defensive and maybe part of the reasons why the stock dropped. Maybe it was a combo of Nasdaq weakness, Presentation and the short selling article in the AFR didn't help. Doesn’t always take much to spook the horses. Plenty of block trades too. $19m in one line. Nice broker work there. 24 big crossing on the day. Rotation happening it seems. Interesting PayPal has released numbers after hours in the US. Best quarter ever. Their BNPL offering going great guns.

• First quarter net profit rose to US$1.10bn from $84m a year earlier, and the company added 14.5m net new active accounts, bringing its total user base to 392m.
• Revenue grew 31% year over year in the quarter that ended Mar. 31.
• About half of customers who’ve tried PayPal’s buy-now-pay-later service used the feature again within three months, with that number rising to 70% over six months.
• PayPal’s TPV on a trailing-12-month basis topped US$1 trillion for the first time.

It will be interesting to try to extrapolate themes from this result to our own 'Aussie Battler' BNPL companies. Stay up to date with what is going on in the Buy Now Pay Later space with daily updates from the Marcus Today team. Try our newsletter for free on a 14-day trial CLICK HERE to get started.