Wednesday, 30 January 2008

Analysis of Warrant Data (Part 4)

The Federal Reserve began a two-day meeting on Tuesday that was expected to end with the second interest rate cut in just over a week, but market confidence in an aggressive half-percentage point drop was waning.

The Fed is mulling its next step to bolster the economy after stunning markets on January 22 with its biggest rate reduction in more than 23 years - an emergency move that brought the benchmark federal funds rate down three-quarters of a point to 3.5 percent.

Since then, investors have widely bet the Fed would keep slashing to head off a recession given worsening financial market conditions.

But after stronger-than-expected data on consumer confidence and durable goods orders on Tuesday, investors scaled back bets on a half-point move significantly.

Short-term interest rate futures showed the implied chances for a half-point cut had dipped as low as 60 percent by midday on Tuesday from 86 percent on Monday. A quarter-point cut was still fully priced in.

The Fed has been trying to minimize the impact from the subprime by cutting rate. The decision was to stabilize the market but then the market is still in a rollercoaster state. This is a good time for us to learn more about warrant and save up your cash then to jump into the market. In this post, I am going to mention two other important aspects of warrant – turnover and outstanding quantity.

Turnover is the total units of a warrant bought and sold on a day, while outstanding quantity refers to the accumulated units, or the accumulated overnight positions, held by investors (other than the issuer) at the close of trading. Outstanding percentage is the portion held by investors of the total units of the warrant in issue. I noticed this information may not be easily gathered. ShareInvestor site does have the outstanding warrant which is updated every Friday of the week and SGX also provides such information.

On a trading day when the market is dominated by day trade investors rather than overnight traders, the turnover can be way above the increase in outstanding quantity. In contrast, if all the new positions of the day are held overnight, the increase in outstanding quantity will be equal to the turnover.

Normally, when a high turnover meets a flat outstanding quantity, what we have is a day trade market. This may be a sign of a lack of confidence in the outlook for the warrant. When a high turnover meets a fall in outstanding quantity, then the market is dominated by sell orders. This may mean that the holders of a call warrant are selling on expectation that the underlying is topping out (or bottoming up in the case of a put warrant). When a high turnover meets an increase in outstanding quantity, the investors here are probably long-term players who are rather upbeat about the market outlook.

Outstanding quantity is more indicative than turnover

In comparison, outstanding quantity is a more significant indicator than turnover. Warrants that make it to the top ten in turnover may lose their followers in just a week. However, outstanding quantity tells you how many people are in the same boat as you. If we look at the price performance, together with the outstanding quantity, of a warrant, we can get a rough idea about whether it is good time to buy or whether selling pressure is building up.

Moreover, the outstanding percentage may reflect the market making the capability of an issuer. Where the outstanding percentage is too high, it shows that the issuer does not have enough holdings on hand for the purpose of price stabilization. In such a case, the warrant price may fluctuate too widely. It may even fall out of step with the underlying price. Hence, such warrants are more risky than others. For example, for a warrant with an outstanding percentage reaching 90%, the issuer will be left with only around 10% of the total units on hand. With the dwindling inventory, the issuer will find it hard to increase the supply in case the strong market demand shows no sign of ebbing. The warrant price may then shoot up to an unreasonable level due to the imbalance between the demand and supply.

In selecting warrants, investors usually focus on the strike price, maturity, effective gearing and implied volatility. Seldom do they pay attention to the outstanding quantity and percentage, which do not bear a direct relation to the value, but at times do affect the price of a warrant. Hence, investors should also know more about the outstanding quantity and percentage of their target warrants.

Reflection of market demand

Changes in the outstanding quantity of a warrant reflect the market demand, rather than the decision of the issuer. When there is an increase in demand and more investors are buying the warrant, the issuer is obliged to provide the liquidity by selling certain units in its holding to the market. Hence, the outstanding quantity will increase. In contrast, when there is a decrease in demand and more investors are selling the warrant, the issuer must buy the excess units in the market. So, the outstanding quantity will decrease.

For some warrants, their outstanding quantities grow as their trading history gets longer. Given that they have a large crowd of investors, these warrants are normally more actively traded. Investors have to be more cautious. Given the high level of outstanding quantity and the large number of participants, the prices of these warrants are subject to a stronger impact of changes in demand and supply and in market sentiment. They are therefore likely to fall out of pace with their underlying. This is particularly at times of heavy buying or selling, when huge trading volume makes it difficult for the issuer to get the market back in order quickly. While these warrants may generate a higher than expected return when they are driven to excesses, investors may also suffer a bigger loss when there is an abrupt market downturn.

How to define a high outstanding level?

Some investors may find the outstanding quantity of a warrant at a high level when it reaches a certain percentage of offer size. Actually, this is not totally correct, as the offer size of a warrant is not limited. Sometimes, a warrant may be reissued again and again, and its total offer size will be relatively large. Some investors may apply for a bigger offer size. With an expanded offer size, the outstanding quantity will of course become lower in proportion. However, this may not necessarily mean that the outstanding level is not high. Investors should refer to actual number of outstanding units as a clue. One should also be aware of the outstanding percentage. If a warrant has a very high outstanding percentage (over 80%), the issuer, with an insufficient inventory on hand, may have difficulty in maintaining the stability of its implied volatility. Hence, whenever there is an imbalance between demand and supply, the implied volatility of the warrant will overshoot, making it hard to predict its price movement.

To find out whether the outstanding level of a warrant is high or low, investors should also take note of the conversion ratio. For examples, both STI 3100 BNP ECW080328 and STI 3100 BNP EPW080328 have the same underlying, strike price and maturity. Yet for STI 3100 BNP ECW080328, the conversion ratio is 1000:1 while STI 3100 BNP EPW080328 is 770:1. Both warrants have an outstanding quantity of 40 million at point of writing. Although one of the warrants is a call and the other is a put, this does not really matter. What I wish to show here is does both of them have the same outstanding level? The answer to the question is no. In fact, the outstanding level for the put is about 1.2987 times (1000 / 770) more than the call. The reason is that each unit of the put warrant represents the right of conversion for 1/770 unit of the underlying, while each unit of the call warrant represents that right of conversion for only 1/1000 unit of the underlying. Hence, for hedging purpose, the issuer has to buy, in theory, 1.2987 times more for put warrant than that of the call warrant of the underlying or over-the-counter options.

Assuming both warrants currently have a delta of 50%. Then for every 20 million units of the call warrant sold or repurchased, the issuer has to buy/sell only 10000 units of the underlying for the hedging purpose. However, for the same quantity of the put warrant sold or repurchased, the issuer has to buy/sell 12987 units of the underlying. Although the difference between the two numbers is not very significant in this example, because I have chosen an index warrant, you will see how great the impact will be for stock warrant. Hence, when the put warrant in our example here is in heavy trading, especially around this period of time, the issuer may face a bigger problem in keeping the order and the warrant price may face a wider fluctuation.

Studying the outstanding quantity is not only helpful for warrants selection, but also indicative of the fund flows in the market. No matter what, before buying a warrant, it would be a nice idea to check out its outstanding quantity. If the level is too high, then you should be careful. In the best case scenario, the implied volatility of a warrant should hold steady after it is bought. In case the warrant’s performance turns funny (for example, the warrant price goes up although the underlying price is unchanged), it may be a sign that the market maker is losing out in maintaining the order of the market. In this case, you should sell the warrant as soon as possible to swap for another with a lower implied volatility. When it’s implied volatility finally goes down to a reasonable level, the price of the warrant will finally goes down to a reasonable level, the price of the warrant will drop even though the underlying price remains intact. This happens when the issuer has restored its holdings on hand or when other investors are selling for fear that the issuer will soon issue additional units of the warrant.

I shall continue my post on analysis of warrant data again. Chinese New Year is round the corner and I hereby take the opportunity to wish everyone a prosperous CNY.

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