MicroStrategy’s secret sauce is volatility, not bitcoin

The saga of MicroStrategy reads like financial fiction brought to life. Its improbable resurrection from near-bankruptcy, its audacious pivot in August 2020 from software vendor to bitcoin maximalist, the thorny legal entanglements, its messianically charismatic leader, its once-in-a-generation stock price performance — all of it defies belief.

Lay on its issuance of prodigious amounts of stock and convertible debt, and the tsunami of stock selling by insiders, and the story gets even wilder. See our previous coverage for a recap.

And the beat goes on. Last month, the company wowed Wall Street by rolling out its fifth convertible of the year — a $3bn, five-year note with zero per cent coupon and a 55 per cent conversion premium to a share price that was already trading at nearly three times the net asset value of its bitcoin holdings — all to fund its relentless quest for more bitcoin.

On paper, it’s genius. The plan is simple: borrow for zero interest with a convertible, buy bitcoin, and pay off the debt when the shares convert at nosebleed prices. As long as the share price stays up — and bitcoin is at least hovering around $100,000 — we are talking about one of the most successful feats ever of financial engineering.

This hasn’t gone unnoticed. Just last week, bitcoin miner Mara jumped on the bandwagon, placing $850mn in convertibles to refinance debt and, naturally, buy more bitcoin. The terms were pretty sweet: zero-per cent coupon and a 40 per cent conversion premium.

So are we witnessing the embrace of bitcoin by the giants of fixed income? The argument goes that access to bitcoin through these convertible bonds is so appealing that bond investors — who are otherwise excluded from cryptocurrency due to their investment mandates — are willing to concede astonishingly favourable terms to issuers. Given the immense scale of bond funds, even a small allocation to such securities could have a seismic impact.

But while funds managed by stalwarts like German insurer Allianz reportedly bought chunks of an earlier MicroStrategy convertible, they’re likely not here for the crypto revolution. The real draw lies in MicroStrategy’s stock — or more precisely, its volatility.

And MicroStrategy is an active and willing accomplice in creating volatility in its own stock.

Convertible bonds are the capital market equivalent of a mullet — serious business in the front (debt), party in the back (equity). They start life as plain old debt but come with a kicker: the option to convert into shares at a pre-determined price. For bondholders, this means downside protection (ie. you’re supposed to get more money back) with upside potential. For companies, the embedded call option allows them to borrow at lower interest rates, as it sweetens the deal for investors. 

In this case, MicroStrategy has essentially created a financial instrument that’s part loan, part lottery ticket. How could it raise $3bn at a zero-per cent coupon and a conversion price of $672.40 per share when the stock was trading at $433? The answer lies in the stock’s explosive volatility, driven by and magnified through its bitcoin holdings. This volatility significantly enhances the value of the embedded call option in the bond, which, in turn, offsets the cost of the bond itself. As a result, the company is able to borrow at rates far below those of conventional debt. 

And volatile it is. MicroStrategy’s stock moves like a hyperactive toddler let loose in a candy store, ricocheting from aisle to aisle with boundless, chaotic energy. Its 252-day historic volatility is currently 106 per cent (implying an average move of 6.6 per cent per day!). The implied volatility of 30-day options in its stock is 2.5 times more than similar duration options in bitcoin itself. And MicroStrategy is unembarrassed by this: in its third-quarter earnings presentation, management crowed about MicroStrategy options trading a higher implied volatility than any S&P 500 stock. 

This sheds light on one of the paradoxes around the MicroStrategy story: why does co-founder Michael Saylor relentlessly hype bitcoin while his company is buying it? Most people would talk down an asset they’re accumulating. 

But for MicroStrategy, volatility is the real currency. Saylor’s bombastic interviews, grandiose predictions, and relentless social media posting aren’t just noise — they’re the fuel for the financial fire. There’s never a dull moment with the guy. The crazier the stock, the better the terms for the next convertible. 

MicroStrategy has effectively engineered its own volatility — and reaped the rewards. Before August 2020, the company’s stock exhibited both realised and implied volatilities in the low 30s. But once MicroStrategy reinvented itself as a binge-buyer of bitcoin, volatility skyrocketed, first surpassing 70 per cent and later breaching 100 per cent. The dynamic is self-reinforcing: acquiring more bitcoin amplifies share price volatility, allowing MicroStrategy to issue convertible bonds on increasingly favourable terms, which it then uses to buy even more bitcoin — further fuelling the volatility. And so the cycle continues.

Historically, convertible bonds in the energy sector have traded at the “richest”, with at most 35-40 per cent implied volatility, and more recently technology company issues have taken it to the 40-45 level. According to IFR, MicroStrategy’s convertible was marketed at a 60 per cent implied volatility — an unprecedented level in the equity-linked market.

Investors in these bonds employ various trading strategies to capitalise on volatility, with one classic approach being so-called gamma trading. This strategy involves purchasing the bond and short-selling the stock, dynamically adjusting the size of the short as the stock price fluctuates to keep the combined position share-price neutral. The net effect is to buy shares low and sell them high, while staying long the convertible.

Here’s how it works: investors start by shorting MicroStrategy’s stock in proportion to the convertible bond’s “delta” — a measure of how sensitive the bond’s price is to changes to the stock price. (The rate of change of the delta in relation to the underlying asset, which in this case is the stock price, is known as “gamma”.) 

Let’s say you buy $1,000 of a convertible bond and the delta is 0.5. So you short-sell $500 of shares.

As the stock price rises and the convertible bond nears being “in the money,” the bond’s delta increases, and you sell more shares to stay neutral. If the delta reaches one, you would be short the same number of shares as you expect to receive from the convertible. Conversely, as the stock falls and the convertible becomes well “out of the money”, the delta decreases, and you buy back shares, reducing the short position. The constant rebalancing generates profits from the stock’s volatility, independent of its overall direction. 

Think of it like harnessing wind energy: the turbines spin as long as there is wind, irrespective of direction. The important factor is the presence and speed of wind, not its orientation. For traders, volatility is the wind that powers their strategy. As for MicroStrategy, its stock is well-suited for this kind of trading: it’s volatile, liquid, and relatively easy to borrow for shorting. 

Now, before you start thinking you can try this at home, stop right there. Gamma trading strategy is not for amateurs. It is complicated, requires constant rebalancing, and is best left to the pros with their models, broker relationships, and trading infrastructure. For the dabblers, potterers and other non-professionals, it’s like watching a performance of fire breathing on a Zanzibar beach — dazzling to watch, seemingly doable by anyone, but you can suffer severe burns if you try it without proper training.

Of course, every flashy financial strategy comes with risks. If the stock calms down, these volatility-driven arbitrage opportunities could vanish, leaving idle and stranded the wind turbines of gamma trading. (This can happen, for example, because investors in convertible bonds are dampening volatility by selling stock as its price climbs and buying stock as it falls.)

MicroStrategy’s volatility has, for whatever reason, cooled in the last couple of weeks, likely leaving some investors nursing losses, although they pale in comparison with the hefty gains enjoyed on previous convertibles.

Another looming risk is that MicroStrategy’s five previous convertible bonds — now deeply in the money, with conversion prices between $143.25 and $232.72 — might ultimately not convert if bitcoin’s price (and, by extension, MicroStrategy’s stock price) plummets. What happens then? How would MicroStrategy manage up to $6.2bn in bond repayments if the tide turns and the principal on the bonds comes due at maturity?

The company’s options would be stark. Its lossmaking software business generates no cash, and its treasure chest of 402,100 bitcoins, currently valued at $39bn, would offer little solace. Selling bitcoin to raise cash would likely be a last resort, but by then, the price of bitcoin would presumably have dropped significantly, exacerbated by the impact of any sales themselves. While convertible bondholders hold a senior claim to these bitcoin assets over stockholders in the event of bankruptcy, the actual “coverage” may prove far thinner than it appears.

And don’t assume the stock can’t tumble below the conversion prices — it was trading below $130 as recently as three months ago. For context, the spot-price value of MicroStrategy’s bitcoin holdings translates to $166 per share. Until February 2024, the stock traded more or less in line with the net asset value (NAV) of its bitcoin. It’s only the hefty premium to NAV that has kept most of these convertible bonds so comfortably in the money.

Anyhow, mitigating this credit risk isn’t straightforward for investors.

One approach is to keep a short position even when the convertible is well out of the money, hedging against the possibility of (or even likelihood that) the company’s creditworthiness deteriorates alongside its share price. But this creates its own challenges. Instead of buying into a falling market (as for gamma trading), investors may find themselves selling shares as the price is tumbling. Depending on size and liquidity, selling into weakness risks being self-defeating; it is not an easy trade to execute.

Nevertheless, for now, the strategy is working wonders. By weaponising its stock’s volatility, MicroStrategy has created a seemingly self-perpetuating loop: cheap funding buys bitcoin, which boosts the stock’s volatility, which secures even better bond terms to buy more bitcoin. The investors? They may or may not be bitcoin believers or Saylor groupies; many are just thrill-seekers riding the wave. As long as the stock keeps zigzagging, the show goes on. But like any high-wire act, there’s always the danger of a fall.

Further reading:
— Examining MicroStrategy’s record-shattering $21bn ATM (FTAV)
— The spectacle that is the bitcoin juggernaut MicroStrategy (FT)