Warrant Tutorial - Part II

We have arrived at the last article of the series. This article is a continuation of the previous article, which has focused on simple trading tactics using structured warrants. This episode will explore the various trading disciplines required to be a savvy warrant trader. So, what does a good warrant trader know?

He knows both the Underlying Stock and the Warrant: The typical warrant trading pitfall is neither knowing the stocks, nor knowing the levels. More than often, investors and traders take a short-term punt on stocks and/or warrants that they have no more then a mere passing acquaintance with. Worse, the entry technical levels are erroneously picked, and the exit levels neglected when blinded with greed. The more savvy warrant investors and traders watch only a handful of stocks, and pick a few warrants amongst the list to follow closely. They can trade a few warrants in the short-term, but they know they can never construct a portfolio of warrants over a medium or long-term horizon. Be nippy and sharp with warrant trades.

A good warrant trader will most definitely be doing technical analysis on the underlying stocks as part of his homework. But he will never extrapolate technical analysis onto his analysis of any warrant. For a warrant, a trader can never pick the absolute bottom or pick the absolute top. He could chart the underlying stock to generate the buy/sell signals before turning to select the trade-able warrants based on warrant variables (implied volatility, effective gearing, time decay, Greeks), but charting a warrant is a disaster in the making. Warrants are constantly influenced by time decay and a chart would need curved trend lines rather then linear ones to take this into account.

A good warrant trader knows the warrant that he is buying – he knows the strike price, the effective gearing, time decay, and the Greeks. There is no point in buying a warrant for a medium term view when it expires in few weeks time. He will also follow another axiom - never buy yesterday’s winners. This applies especially in warrants, which have made a huge move. The delta might have increased significantly, while the effective gearing drops drastically. If a warrant doubled up yesterday, chances are that both the smart trader and the issuer would want to focus on another warrant with a higher strike level. The trader wants to maintain good gearing, while the issuer wants to maintain reasonable delta. Bear in mind that when the delta gets too high, the warrants could suffer from the wide bid-offer spreads posted by the market maker (recall article 4). Due to the minimum tick size of the underlying share, a very high-delta 1-for-1 warrant could be quoting close to X ticks apart, defined by the minimum tick size of the underlying share. If the underlying share move 10 sen a tick, a very high-delta warrant has to maintain a 10 sen spread too.

Would a good warrant trader “chase” a warrant? The question is no different from “would he chase a stock?” If the stock continues to move upwards, he would most likely trade the momentum using the warrant. Waiting for any retracement only for it never to happen could be a poor warrant trading strategy, but do bear in mind that timing the move is extremely important in warrant trading. Yes, part of winning in the warrant trading game is protecting your capital like a bull terrier, but warrants, by itself, is a momentum instrument. Hence, do trade the momentum.

Would a good warrant trader average down? He would not. The trend is a trader’s friend – he would never fight it, especially in warrant trading. If the underlying share is heading down, do not buy the call warrants, or average down, in anticipation of the turn. Remember these: (a) if the directional view is wrong, the warrant will be a double-edge sword that could cut deeply; (b) even if the stock consolidates after the selldown, the warrant will still suffer time decay. A 50% loss requires a 100% gain to get back to the starting point. Never test the lower limit of any structured warrant. One could well ask the question “how low can it go?” on a stock, but on a warrant, the answer is - ZERO! If, however, the trader thinks that the trend is going to remain downwards, he would have taken a look at some puts rather then calls. Do not stay fixated.

He Knowing Volatility: Because volatility is priced into any warrant calculation, a change in the volatility element will have an impact on the price at which a warrant is trading. With several warrant issuers in the market issuing warrants on the same underlying stock, the conventional belief is that investors and traders should look only at the warrant with the lowest implied volatility. But this is only true if the issuer buy back their warrants at a proportionate volatility level. To illustrate, one is better off buying a warrant at a volatility of 60%, and sell it back to the issuer at 55% than to buy a warrant at a volatility of 40% and sell it back at 30%.

The key issue that a warrant trader needs to consider when looking at volatility is not necessarily the absolute level of the volatility the warrant is priced at but rather the level at which the issuer is willing to buy back the warrant. This means consistency in managing volatility on the issuer’s part. Some issuers will change implied volatility intra-day whilst others hardly ever make adjustments. Recall that theta/time decay is one of the often-ignored Greeks in warrants and yet it can be a silent killer.

But this card is only played in favour of the issuers. Or is it?

While it is true that a warrant will lose an amount to the time decay, it is crucial to time the entry and exit points on warrant trades. Buying a call warrant only on strong upward move after periods of consolidations means the position has skipped a long period of time decay compared to holding the same warrant across the lull period. It also means that there is lesser room the issuers could manage volatility in the pricing process. In the extreme cases, issuers will move the implied volatility in favour to warrant buyers. This has happened in cases spurred by sudden market shocks, like a catastrophe or a war.

On very short-term warrant trades, time decay and volatility may be less of an issue. Else, a good warrant trader will trade only the momentum, and trade especially the breakouts.

He Knows the Issuer and Liquidity: Without a doubt one of the merits of structured warrants is that there is a guaranteed liquid market with the issuer committed to be a buyer at all stages and seller as long as the delta is low. What this means is that should all other buyers dry up, a warrant holder will still be able to sell to the issuer at their “fair value” for the warrant. However, in reality, this seldom materialises for warrant markets at infancy stage. Yes, the issuers are always in the market, on both sides of the spread, but the spread could be less than efficiently tight. At issue is the fact that the laws of supply and demand do not necessarily kick in when issuers make their spread. The spread is controlled by the issuer and is just an "adjusted view" of the underlying stock, while the issuer supports the "fair value" of the warrant.

There is a school of trading thought that favours liquidity - unless a warrant engage serious volume everyday, they will not trade it. This is true in the early days of warrant trading, when the warrant details are not readily available. In those days a liquid warrant was undoubtedly a better deal. In current times, with information abundant, the volume of warrant traded is of less importance when selecting a winning warrant. In fact, chasing the most liquid warrants may lead one to engage in the wrong trades in warrants that are totally unsuited to his risk and trading profile. Always trade warrants with as tight a spread as possible, as opposed to the heaviest volume traded warrant. They could happen to be the same warrant, but identify a warrant trade to enter and exit at the issuer's level, rather than hope that the rest of the market helps to bid the trade out.

Of equal importance is that the spread on the underlying share has to be tight and liquid. Do not trade a warrant of which the underlying share exhibits a tendency to trade with a huge spread periodically. As long as the underlying stock is liquid there will never be a concern about the liquidity of the warrant. This is because issuers hedge their position in the underlying stock - as long as they are able to do this hedge they can make more and more warrants available at that same price – thus making the warrant as liquid if not more so than the underlying share.

He Knows Himself: More often than not, warrant investors and traders alike lose the discipline and became scattered-brained with the inherent risks of structured warrants. Fixation on the direction and target price of the underlying stock means that risks of leverage and time decay are forgotten. Anything that can move 100% or more in a few days can also lose 90% in the same period. The rewards justify the risks but the risks are great. Adding to the risk of gearing are well out-of-money warrants which will expire worthless and often spend the last couple months trashing investors’ and trader’ confidence as they tend towards zero.

The golden rule to reduce the risk is to always use a cut-loss strategy. Also, do not over leverage the portfolio - invest only a small portion of the entire portfolio in structured warrants.

Be honest with the personal assessment of risk. It is important that a potential warrant investor or trader fully understands the risks before leaping in on warrant trades. The rewards are high, but so are the risks. Thus the money is better not coming from his retirement fund. He needs to trade warrants with money that he can fully risk losing. Good portfolio management would make it almost impossible to lose all the money, but for warrant trades, it happens.

Do some paper trades before trading warrants with real money. This allows a trader to develop a system without incurring risk and any lesson learnt over the paper trade would not cost a single sen. Construct a fictitious portfolio and trade stocks and warrants using warrants only to leverage the portfolio when the timing is right. While it is horrendous to see how right some trades can be, unfortunately only on paper, at least any losses will not cause any sleepless nights and undue stress. After a few months, the new warrant trader will realise that warrants could well be used as a leverage tool when the timing is appropriate.

Final Thoughts: Trading warrants entails high risk and high rewards. In many markets, structured warrants are viewed no different to penny stocks. Often, we hear horrid market tales of investors and traders losing money in structured warrants, yet they remain silent on their loss of their portfolio on penny stocks and even blue-chip shares. In essence, the same trading principles apply to both shares and warrants. Following the principles in the face of greed and fear is, however, the tough part. But it does not mean it cannot be done and stay profitable.