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Volatility & Warrant

Question: In view of the high volatile market, do you think one should continue to invest in warrant as doing warrant will increase one's exposure to higher volatility in the already highly volatile market. I had a discussion with on friend on that but i disagree with him on the current situation that we should be buying the underlying instead of adding more volatility by leveraging on warrant. My view is that we cannot lower the volatility through warrant but we can control the risk exposure by lowering the trade value of warrant and yet achieve a comparable risk/gain/loss. Am i right to say that? An example would be a $20 share and a 10c warrant with June/July expiry, out of money warrant. Conversion is 10. A very vague guide but what i want to say is by varying the trade size, we can achieve good exposure with comparable risk.

Comment - Warrants trading in a down trend marked with intense volatility is not for the faint hearted, but to me, a genuine warrant player absolutely loves this market. Intense volatility and grave mis-pricing, the best kind of markets to trade warrants. If you are cashed out, maybe you can risk 10%-20% of capital to do this. Its pretty simple.

Follow some basic rules:

a) Do not buy on up days, buy on down days where mis-pricing is more readily available. You also have a buffer buying on down days.

b) Throw out all warrants with less than 30 days to expiry.

c) Only consider those with Effective Gearing of more than 5x and a Premium of Less than 20%.

d) Preference to those with lower absolute prices, i.e. a 10 sen warrant is better than a 30 sen warrant.

e) Sell on up days. For the assumed risk, you should be expecting 30%-50% return per trade.

f) Because you selected those with high gearing and low premium, even on further down days, the warrant price would not fall by a big percentage. Set a cut loss level.

Like I said, this is not for everyone.


bantersy said…

Sincere thanks for taking the time to reply especially at wee hours. Haa...

These days, I noted the wild swing in the pricing as for example, in a volatile day where the price of underlying swing (+/-)5%, the warrant is priced in extreme end for put and call. Say if you buy the put warrant at 20c today when the underlying is $18(intra $1 swing), at the next day, the underlying increases in price to say $18.40, the put can actually went up in price - moving in tandem with the call as well. This is crazy. Either the mispricing during the wild swing or at a calmer market day, market maker is pricing the warrant at a higher premium to force people to buy at that price should they want to. On the third day, it actually swapped down the price again to 18-19c when the underlying again, resume their fall back to say $18.

What I want to highlight is market market, most of the time is the issuers themselves, are doing a lot of mispricing with regulator allowing them to retort to such "bully" behavior. This is a real experience I had few weeks ago. Market maker was happily throwing down 6 million of warrant to the buy queue. Guess what, the underlying is still going up. The next moment, it swapped the bid/offer down by 1 bid. A obvious case of "eating" the retailers/institutional players.

Without proper governing on the pricing mechanism, this type of scam is a misfortunate and warrant participants have to factor such element in their warrant equation, or what Benjamin Graham said, margin of safety.

Dali, you talked about grave mispricing. But there is one variable inside the schole equation or what you had posted way earlier on warrant's equation, that MM can always use that to swing the bid/offer in their favor. Eg. which you already know widen the spread.

Well, you may say that such mispricing is temporary and stretching it into days, the correct pricing will be reverted.

Any thoughts?
Tony said…
Warrant trading is like playing Baccarat. You see a long trend of banker bets and you decide its player's turn and vice versa. I think the house edge (brokerage) will kick in, in the long run. In heavily traded warrants I find it difficult to spot any mis-pricing. But then again, a warrant is an option to buy or sell into the future, so what is fair value? Optimism or pessimism waxes and wanes with each market day., so premiums follow.
General said…
Very good article. (Tougue in cheek) The time now is 10.22pm on 30Jan2008
Salvatore_Dali said…
first of all, general, i don't know if you are saying its a good article, or its a bad article... tongue in cheek usually means the reverse... if you did not like it, at least say why you did not like it so I may improve..

market makers get the rough dig all the time, they are there to make money, not to act like a saint... the prob we have here is that other houses / market makers are not yet trading in each other's warrants like they do in HK in a big way... thats why its very hard for a market maker to play tricks in HK, somebody will kill their positions.. bursa and sc are still learning the ropes... I hope they hire me in some capacity (lol)... but you know better
bantersy said…

you are right, they are the dealer and shall have the house's edge in the end. for heavily traded warrant, it is also right to say that MM will find it harder to play tricks as the high volume explains the efficiency to a certain extent. thinly traded warrants usually are out of favour due to their unattractive spread or pricing.

i think when houses are not traded against one another, they lower their guards, resulting in more mis-pricing and offer opportunity for arbitrage. sometimes, i do observe, if i read correctly, MM will retort to unscrupulous act to force proprietary traders when they detected sign of activities. poor retailer like me will be the victim of their fight.

as for now, there is still plenty of good opportunity to trade warrant. am still learning more.

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