Infinite Money Glitch: How MicroStrategy Convertible Bonds Profit from Gamma Trading — Part 1

Infinite Money Glitch: How MicroStrategy Convertible Bonds Profit from Gamma Trading — Part 1

What if I told you there’s a way to make money in financial markets no matter which way a stock moves? Sounds like a cheat code, right? Welcome to the world of gamma trading — the sophisticated strategy hedge funds use to turn market volatility into a profit machine. And few playgrounds are as exciting as MicroStrategy (MSTR), a company whose stock rides Bitcoin’s roller coaster with reckless abandon.

Imagine this: You’re a hedge fund that bought $1 billion worth of MSTR convertible bonds when the stock price was $500. The bonds pay no interest (0% coupon) but come with a magical feature: the option to convert into shares at a price of $630. Now, the stock falls to $370 before skyrocketing to $800. How do you make money in both scenarios? The answer lies in gamma trading — a strategy that thrives on the chaos of stock price swings.

Let’s break it down step by step, because beneath the jargon is a system so elegant that it might just redefine how you think about money.

TLDR — Summary — The Mechanics of Convertible Arbitrage

Convertible bonds are hybrid securities — part debt, part stock option. Hedge funds don’t just hold these bonds; they actively hedge their positions by shorting the underlying stock and adjusting their exposure as the stock price moves. Here’s where delta (sensitivity to stock price changes) and gamma (rate of change in delta) come into play:

1. Initial Hedge:
   At $530, the bond’s delta is 0.5. This means the bond behaves like owning 50% of a share for each bond. To stay neutral, you short 500,000 shares (1 million bonds × 0.5 delta).
2. The Drop to $370:
   As the stock price plummets, the bond’s delta drops to 0.3. You adjust by buying back 200,000 shares (shorted earlier at $530). The profit? A cool $32 million from the price difference.
3. The Surge to $800:
   When the stock rallies, the bond’s delta approaches 1. You short 700,000 additional shares, locking in profits on shares bought back earlier at $370. The payoff? Another $86 million.

By the time the dust settles, you’ve pocketed $118 million in gamma trading profits — all without betting on whether the stock would rise or fall.

Mathematics

This strategy involves managing two key positions:

1. Owning convertible bonds, which are a mix of debt and stock options.
2. Short-selling stock, adjusting the size of the short position as the stock price changes.

Here’s how it works, step by step.

Key Assumptions and Setup

Convertible Bond Details

• Face Value: $1,000 per bond.
• Quantity: 1 million bonds.
• Total Investment: $1 billion.
• Conversion Price: $630 per share.
• Delta: Initially 0.5, meaning the bond behaves like owning half a share of the stock for each bond.

Stock Prices

• Starting Price: $530.
• Price Drop: $370.
• Potential Run: $800.

Trading Framework

• Gamma Trading: Constantly adjust the short position to profit from price movements.
• Short Position: Hedge the bond’s stock exposure by shorting the corresponding number of shares.
• Delta Adjustments: Change the size of the short position as the stock price fluctuates.

Step 1: Setting Up the Hedge at $530

At the starting price of $530, the delta of the convertible bond is 0.5. This means the bond behaves like owning 50% of the stock’s value.

Hedge Setup

To neutralize the bond’s stock exposure:

• The hedge fund shorts 500,000 shares (1 million bonds × 0.5 delta).
• The short position’s value is:

At this point, the portfolio is delta-neutral, meaning small stock price changes won’t significantly impact the fund’s overall value.

Step 2: Profiting as the Price Drops to $370

When the stock falls to $370, the bond’s delta decreases to 0.3. This is because the stock price is now much lower than the conversion price of $630, making the bond less sensitive to the stock’s movements.

Hedge Adjustment

• The hedge fund only needs to short 300,000 shares at this lower delta (1 million bonds × 0.3 delta).
• It had previously shorted 500,000 shares, so it buys back 200,000 shares at $370 to adjust the position.

Profit Calculation

• The 200,000 shares were initially shorted at $530 and bought back at $370.
• Profit per share:

• Total profit:

The fund has now locked in a $32 million profit from this downward move.

Step 3: Profiting as the Price Rises to $800

If the stock rebounds to $800, the bond becomes deep in-the-money (the stock price far exceeds the $630 conversion price). In this case, the bond’s delta increases to 1, meaning it behaves like the stock itself.

Hedge Adjustment

• The hedge fund needs to short 1,000,000 shares (1 million bonds × 1 delta).
• It had previously shorted 300,000 shares, so it now shorts an additional 700,000 shares at $800.

Profit Calculation

• Earlier, 200,000 shares were bought back at $370, but they are now shorted again at $800.
• Profit per share:

• Total profit:

The fund has now locked in an additional $86 million profit from the upward move.

Final Position

• The short position (1,000,000 shares) perfectly matches the bond’s delta.
• When the bond is converted into stock, it covers the short position, leaving the hedge fund with no further exposure.

Summary of Profits

From the Price Drop ($530 to $370):

• Profit: $32 million.

From the Price Rally ($370 to $800):

• Profit: $86 million.

Total Profit:

Additional Considerations

Interest on Short Sales:

• The hedge fund earns interest (or a rebate) on the cash generated by short-selling the stock, adding to its profits.

Borrowing Costs:

• The fund incurs costs to borrow the shares it shorts, which vary depending on stock availability.

Volatility Premium:

• The real driver of profits is the volatility of MSTR’s stock, which creates frequent opportunities to adjust the hedge.

Why This Works: Volatility is Gold

Gamma trading isn’t about predicting the market — it’s about capitalizing on volatility. Every price swing, up or down, is an opportunity to adjust your hedge and lock in profits. MicroStrategy’s stock, with its wild Bitcoin-fueled price movements, is the perfect candidate for this strategy.

In essence, this isn’t traditional investing; it’s a volatility arbitrage. The hedge fund profits from frequent recalibrations, not from holding a directional view of the stock.

The Infinite Money Glitch: Why Convertible Arbitrage is So Powerful

• Dynamic Hedging:
  Delta tells you how much stock exposure to hedge. Gamma ensures your delta changes with every price move, creating endless opportunities to adjust positions.
• Risk Mitigation:
  By hedging constantly, the fund minimizes exposure to wild swings while maximizing the profits from those same swings.
• Volatility Premium:
  The real driver here is volatility, not the stock price itself. The more unpredictable the price, the greater the profits.

Final Thoughts

At its core, this strategy is less about betting and more about engineering profits. Hedge funds in the convertible bond market use tools like gamma trading to turn turbulence into treasure. And while it might seem like an infinite money glitch, the reality is that it’s a calculated, data-driven dance with market chaos.

Infinite Money Glitch: How MicroStrategy Convertible Bonds Profit from Gamma Trading — Part 1 was originally published in The Capital on Medium, where people are continuing the conversation by highlighting and responding to this story.