This post is a continuation of my previous post on Analysis of warrant data. Some of you might have known this already but to make it more complete, I will try not to miss out anything about warrants. What do we mean when we say a warrant or option is in-the-money? A warrant is described as in-the-money (ITM), at-the-money (ATM) or out-of-the-money (OTM), depending on the relationship between its strike price and its underlying price. A call warrant is OTM when its strike price is higher than its underlying price. In contrast, when its strike price is lower than its underlying price, the call warrant is ITM. The situation is just opposite for put warrants. When its strike price is higher than its underlying price, a put warrant is ITM; and when its strike price is lower than its underlying price, it is OTM. No matter it is call or put, if the strike is equal to the underlying price, the warrant is said to be ATM. The above is summarized below:
- In-the-money : Call warrant – Strike price less than Underlying price
- At-the-money: Call warrant – Strike price equals Underlying price
- Out-of-the-money: Call Warrant – Strike price greater than Underlying price
- In-the-money : Put warrant – Strike price greater than Underlying price
- At-the-money: Put warrant – Strike price equals Underlying price
- Out-of-the-money: Put Warrant – Strike price less than Underlying price
If we take into account the extent of the difference between the strike price and the underlying price, warrants can be further classified into ITM, deep ITM, OTM and far OTM. Generally, where there is a 15% or above difference between the strike price and the underlying price, a warrant will be considered far OTM or deep ITM. However, this 15% mark is merely a rough idea, not an absolute threshold. One must also look to the volatility of the underlying. Some warrants may be considered deep ITM or far OTM even if the difference between strike price and the underlying price is only 10% or more.
Besides classifying warrants in term of moneyness i.e. ITM, OTM or ATM, warrants can be classified accordingly to the length of their remaining days to maturity. Normally, we will describe a warrant with less than 3 months to maturity as a short-term warrant; one with 3 to 6 months left to maturity a medium-term warrant; and one with more than six months running to maturity as a long term warrant.
If we also take into account whether a warrant is ITM, ATM or OTM, a general investor may consider a medium-term warrant with around 3 months running to maturity and a strike price around 5% above or below the underlying price. More aggressive investors may go for OTM warrants with a shorter maturity. For conservative investors, they may choose ITM warrants with longer maturity.
Whether it is long-term or short term, ITM or OTM, a warrant is after all a leveraged investment instrument. Be cautious in funds allocation and stop-loss arrangements. Do not get carried away by the potential return without considering your risk tolerance.
Personally, if I am willing to invest say, SGD$400 to buy warrants, then SGD$400 is the amount I am willing to lose if I hold onto maturity and the warrant expire OTM. Hence, be very careful with your money management. If you do not intent to hold the warrant till maturity, then as a general guideline, sell off your warrants 30 days before they get expire. Another personal advice from me, although we can trade warrants like stock meaning we are able to short sell warrants, please DO NOT ever do it, unless you really know what you are doing? I will keep up with my posting on warrants soon. Have a nice day. Oh, please kindly vote in my blog too. :)