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Covered Warrants - The Not So Silent Killer

One should never never punt on warrants with less than 1 year to expiry, especially covered warrants. I can safely bet that anyone who trades in covered warrants in the course of a year will have a 90% chance to sustain losses. 

Unfortunately, our markets have been in the doldrums for the past 6 months or so and that has caused some die hard players to only consider covered warrants, esp those index covered ones, in particular the highly volatile HSI covered (which kind of acts as a proxy to the even more volatile China exchanges).

Just have a look at the daily volume rankings, its always the covered warrants for the past few months. Strange as it may seem, if things continue, our local exchange will be trading mostly other countries' covered index warrants for the longest time - esp if the big guys introduce the Nikkei covered as well.

Why investors will lose big in the long run:

1) Time Value - These covered warrants are usually short in terms of time to expiry, usually less than 12 months. Investors are usually lured into covered warrants when their absolute price are less than 30-40 sen because they think they get a lot of leverage. But to get to 30-40 sen, it also usually meant that there is less than 6 months to expiry, and trust me, the time value diminishes rapidly. Even if the linked product stays stationary, you will find the price of the CW dropping.

2) Your opponent - Unlike a company's warrant, in CWs there are teams of experienced traders (issuers) with sophisticated models fighting you on the other side. If you think the role of issuing house is to MANAGE their gammas and betas, YOU'D be very wrong. The safest way to make money for issuers is just to manage and capture the premium, manage free float, and make sure you are well hedged. MUCH LIKE THE CASINOS - they almost never ever lose... so guess who wins and loses in the end. Better to go Genting, seriously.

Even when you keep wanting to buy, they will keep giving you the volume to buy. They can keep throwing new shares at you as long as the equation is right. What you see on the screen being offered is never what they "really can sell" to you.

3) Volatility - The die hards will say they trade only the highly volatile CWs such as HSI. Yes, thats a better strategy but I can also tell you that the higher the volatility, the higher the premium that is priced into these CWs, and it will take a hefty whack in movement to erase the premium before you see good gains.

4) One Sided - You know very well the issuers KNOW you can only take ONE SIDE of the equation. So overtime you show up on the screen, either you are buying or buying. At any point in time, they know how many people are long or short out there. Imagine playing black/red, but you can only bet red and the odds are always 0.7 to one instead of 1 to 1.

5) Timing - The nature of the product necessitates the need to TIME your entry point accurately. So, unless you are the type that can walk between raindrops to avoid getting wet - fergedaboudit.

The next time you think of trading a CW... just picture the trading/hedging teams at the banks, you can almost invariably see them laughing and chuckling to themselves at how easy it is to make money from the market (that means you and me).

p/s my first 8 years of my career was spent placing, trading and managing the house book on Japanese corporate warrants for Nomura and James Capel


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