Actual Operation of Warrant Trading (Part 6)

This is the last post of the Actual Operation of Warrant Trading. In our last post, we will talk about the last trading day, expiry date and payout date.

If an investor waits until the maturity to ask the broker to sell his warrant holdings on hand, the instruction may be rejected. It is because that the last trading day has passed!

If it is only at the last minute that you find out the last trading day is before the expiry date, you might have lost the last chance for selling. Under the requirements of the Singapore stock exchange, the last trading day of a warrant must be the fourth trading day (excluding any Saturday, Sunday or public holiday) before its expiry date. In fact, investors may work that out for themselves with reference to the expiry date disclosed by the issuer.

Let us look at the example of SPCSGAECW081013. From the code, the expiry date is on the 13th October 2008 and the last day of trading will be on 7th October 2008 that is fourth trading day before expiry. Based on these terms, the trading came to an end after 7th October 2008.

When a warrant has expired, the issuer will transfer the settlement amount to the securities settlement account of the investor through the Central Depository (CDP). Generally, the payout date is around three working days afterwards when the money is transferred to the CDP (depending on the specific arrangements of the issuer concerned). The money will then be redirected to the investor by his or her broker or bank.

There will always be 5 valuation dates. In other words, the closing price of a valuation date may be used twice should there be a Market Disruption Event (MDE) on the previous valuation date. The Macquarie Warrant Hotshot competition begins today at 0900H, all the best for those who have sign up for the game.

Actual Operation of Warrant Trading (Part 5)

With the Macquarie Warrant Hotshot Competition starting tomorrow, it is time for me to post the last two posts on Actual Operation of Warrant Trading. In this post, we will focus on the calculation of settlement price.

The method of calculation of settlement price differs for stock warrants, index warrants and other types of warrants. In general, it is not as complicated as one might think. We will discuss only the calculation method for standard warrants. We will not be touching on the settlement for exotic warrants.

Stock Warrant

The settlement level of a stock warrant is the average closing price of its underlying for the five trading days immediately preceding the expiry date. This is true across most of the warrant issuers that I have studied. Take for example, the call warrant OCBCSGAECW080707 which is issued by Société Générale (SGA) on the underlying OCBC counter which expires on 7th July 2008 with a strike of S$8.00. The conversion ratio on this warrant is 1:3 which means we need three warrants to convert into a single OCBC stock.

The settlement calculation is computed as follow,

For call: Max { [(Settlement Price – Strike Price) ÷ Conversion Ratio ] ÷ Exchange Rate., 0 }

For put: Max { [(Strike Price - Settlement Price) ÷ Conversion Ratio ] ÷ Exchange Rate., 0 }

Based on the above formula, we need to know how to compute the settlement price so we can do the computation for the settlement at expiry.

From the screen capture above, the last five trading days prior the expiry date of the call warrant on 7th July 2008 are 30th June, 1st July, 2nd July, 3rd July and 4th July. Notice 5th and 6th July are weekends and are not consider part of trading days. The settlement price is calculated as follow, based on the closing price at the end of each trading day.

(S$8.17 + S$8.07 + S$8.15 + S$8.08 + S$8.05) ÷ 5 = S$8.104

This is above the strike of S$8.00 which is ITM and hence the settlement calculation is

Max { [(S$8.104 - S$8.00) ÷ 3] ÷ S$1.00, 0 } = S$0.034667 per warrant.

Hence if you have bought 10 lots of OCBCSGAECW080707, you will have receive a payment of S$0.034667 X 10 X 1000 = S$346.67.

Let’s take a look at the call warrant SPCSGAECW080707 on the underlying SPC counter which expires on 7th July 2008 too with a strike of S$7.88. The conversion ratio on this warrant is 1:5 which means we need five warrants to convert into a single SPC stock.

The screen capture above showed the last five trading days prior the expiry date of the call warrant. Again, the settlement price is calculated as follow, based on the closing price at the end of each trading day.

(S$6.60 + S$6.72 + S$6.83 + S$6.95 + S$6.91) ÷ 5 = S$6.802

Notice this is below the strike of S$7.88 which is OTM and hence the settlement calculation is

Max { [(S$6.802 - S$7.88) ÷ 5] ÷ S$1.00, 0 } = S$0.00 per warrant.

Hence if you bought 10 lots of SPCSGAECW080707, you will not receive anything in return.
Option trader might find the settlement of warrant is quite different from that of the option. The different being the settlement price is taken from the average of the last five trading days of the underlying rather than the last closing price of the underlying one day prior to the expiry of option.

The rationale behind such approach is to prevent anyone who has enough capital to move the stock price of the counter through market manipulation such that the warrant will become ITM at expiry. Take for example in the case of the SPC call warrant above. Suppose the strike of this warrant is S$7.00 instead of S$7.88 and if the settlement calculation is computed based on the last closing price on the trading day prior to the expiry of the warrant. If a person or an institutional investor has enough capital to buy into the SPC stock at near the closing bell of the day to push up the price of the SPC counter to be above S$7.00, say S$7.10, then for each warrant the investor holds, he or she will receive S$0.02 per warrant at settlement.

Of course this is a hypothetical situation but it is not possible in real life. Having the average of the last five trading days’ closing price as settlement price is to prevent such market manipulation from happening cause it is more difficult to move the stock price for five consecutive days than in a single time frame at closing bell. However, if the investor does have the capability to move the stock price for five consecutive days, the Singapore Exchange may already halt the trading of the underlying before further manipulation happens.

Index Warrant

The settlement level of an index warrant differs across different issuers. I have listed the method of settlement for the Straits Time Index (STI) for various issuers below based on my findings.

1. For Société Générale (SGA), the settlement for the STI is based on the final settlement of the future contract of the STI. The future contract settlement for STI can be found here.
2. For Deutsche Bank (DB), the settlement for the STI is based an amount equal to the reference level on the valuation date or an amount equal to the arithmetic average of the reference levels on all the valuation dates, as determined by the issuer and without regard to any subsequently published correction.
3. For BNP Paribas (BNP), the settlement for the STI is based on the five days average closing price of STI.
4. For Macquarie Capital Securities (MBL), there is no warrant issued for STI that I can find.
5. For Rabo Bank (RB), I cannot find any settlement details on how they compute for both equities and index.

The formulae used to compute the settlement calculation for index is the same as the ones used to calculate for stock. For example, the settlement for put warrant STI3200SGAEPW080627 on the underlying STI which expires on 27th June 2008 with a strike of 3200 and conversion ratio of 500 is as follow,

Max { [(3200 – 2947.8) ÷ 500] ÷ S$1.00, 0 } = S$0.504400 per warrant.

The settlement level 2947.8 is gotten from the Singapore exchange website. See the screen capture below.

Please do take note that the settlement for HSI index listed in Singapore exchange by various issuers may have a different settlement procedure compared with STI. I have listed the links below where you can find the calculation of the settlement for all the expired warrants by different issuers.

1. For Société Générale (SGA), the settlement details can be found here.
2. For Deutsche Bank (DB), the settlement details can be found here.
3. For BNP Paribas (BNP), the settlement details can be found here.
4. For Macquarie Capital Securities (MBL), the settlement details can be found here.
5. For Rabo Bank (RB), I cannot find any settlement details on how they compute for both equities and index.

I hope this post has given my readers an idea on the settlement for both Singapore equities and Index. The same formula can be used to compute for plain vanilla warrants issued on equities or index in Hong Kong or Japan. We just need to pluck in the exchange rate in this case and also find out on how the settlement level is determined.

Macquarie Warrant Hotshot Competition

For those who have been trading options, you will realize that there are a lot of virtual trading platforms out there for you to practice your strategies and polish up your skills. Unfortunately, this is not so true for warrant trader. I do my own virtual trade on a spreadsheet I created but then it lacks the real time data feed.

Macquarie is organizing the second Warrant Hotshot competition which is a real-time simulated trading contest designed to improve your knowledge of warrant investing without risking any capital. In fact, you could stand to win the S$20,000 Grand Prize if you are crowned Singapore's Warrant Hotshot.

The Hotshot contest is suitable for investors of all skill levels from newcomers to experienced warrant traders. Participants will begin the contest with S$100K Hotshot dollars and prizes will be awarded to those who are able to generate the largest profits by trading Macquarie warrants in the simulated trading environment. Warrant prices in the contest will mirror the real warrant prices on the SGX.The competition will be segmented into four main categories: dealers, investors, media and students, with participants from each category competing against each other for the weekly and group prizes. There will also be a grand prize winner for the investor with the largest portfolio at the end of the competition.The contest is scheduled to start on 14 July 2008 and will run for a period of 8 weeks. Please click here to register.

You can register under the appropriate category. For convenient sake, I have re-posted the Rules and Regulations here for your reference.

Introduction

Macquarie is pleased to present the second Macquarie Warrant Hotshot contest to investors. The contest is designed to give new and existing warrant investors the opportunity to experience trading warrants in a real-time simulated environment. Live pricing for both warrants and their respective underlying will mirror those seen on the SGX main board.

Eligibility

• Participants must be aged 21 years or above at the time of registration.
• All staff and their immediate family members of Macquarie Capital Securities (Singapore) Pte. Limited (Registration Number 198702912C) and Macquarie Capital (Singapore) Pte. Limited (Registration Number: 199704430K) and their related body corporate are not eligible to receive any prizes in this Macquarie Warrant Hotshot contest.
• Participants can be of any nationality.
• Participants must be residing in Singapore.
• To be eligible for any prize, the following conditions must be met:
1. The Participant must have complied with the rules and regulations stated.
2. The Participant must have completed at least one (1) buy trade (using the virtual cash in the Hotshot Account) during the term of the contest.
3. The Participant must not have been disqualified from the contest.

Registration

• Participants can sign up for only one Hotshot Account. Participants must register their own personal particulars, and not use another person's particulars to register for the contest. Participants must not trade using another participant's Hotshot Account.
• Participants must register using their names as stated in their NRIC or Passports. NRIC or Passport numbers registered must be valid and accurate to be eligible to win a prize. Participants who fail to produce a valid form of identification will not be awarded cash prizes should they be declared winners for the respective prizes. Driver licenses will not be acceptable.
• Participants must register in their appropriate category i.e. Remisiers and Dealers, Private Investors, Media and Students. Any participant competing in the Remisiers and Dealers, Media or Student categories will be asked for proof of their employment within these industries (or proof of study for the student category) before any prizes are awarded. A letter from their respective companies and institutes of learning, along with their NRIC or passport may be required for verification. Participants working in any publishing, or broadcasting company qualify as Media participants. Participants who have doubts as to whether they qualify for a particular category may contact the warrants team at 1800 288 880. Any participant competing in the wrong category will not be eligible for any prizes.
• Participants must agree to be bound by the Rules & Regulations set by Macquarie Capital Securities (Singapore) Pte. Limited.
• Macquarie Capital Securities (Singapore) Pte. Limited reserves the right to change the Rules & Regulations of the contest, and will disqualify any participants breaching the rules stated herewith.
• Macquarie Capital Securities (Singapore) Pte. Limited also reserves the right to disqualify any participants attempting to tamper the trading system or influence the warrant prices by manipulating the underlying prices. Any breach of market misconduct will be reported to the SGX and / or the Monetary Authority of Singapore.
  Participants can sign up for the contest anytime from 30 June 2008 9am by completing the registration form online at http://www.warrants.com.sg/.
• In case of any dispute, Macquarie Capital Securities (Singapore) Pte. Limited will have the final discretion in the award of any prizes.

Contest & Prize Details

• The contest will last for 8 weeks, starting at 9:00 am on 14 July 2008 and ending at 4:59 pm on 5 September 2008.
• Each participant will start the contest with an initial credit of 100,000 points, with every one point being the hypothetical equivalent of one Singapore dollar.
• There is a "reset" option (My Portfolio -> Personal Portfolio), where players can start over with a credit of 100,000 points, and have their previous trades deleted. They will not be eligible for the Weekly Hotshot Prize for that particular week. However, they will still be eligible for the Grand Hotshot Prize as well as the Category Hotshot Prize.
• There will be 4 categories: 1) Remisiers and Dealers 2) Private investors 3) Media 4) Students. Participants can track the names of the top 5 Hotshots in each category on the contest website.
• There will be four winners for the Weekly Hotshot Prize each week. The weekly winners will be the participants in each of the four categories with the highest percentage gain in his or her portfolio that week. The percentage gain in the portfolio is measured from the close of market on Friday that week, and comparing it to the Friday before. E.g. For the week starting 21 July 2008 and ending 25 July 2008, the percentage gains for that week will be calculated as:
  

  (P25 - P18)/ P18 x 100%
  

  where P25 is the total credits of the portfolio at the close of 25 July 2008 and P18 is the total credits of the portfolio at the close of 18 July 2008.

• For warrants over Singapore stocks, the market value of a participant's holdings will be calculated based on the warrant bid price at 4:59 pm.
• For warrants over Hong Kong stocks, the market value of a participant's holdings will be calculated based on the warrant bid price at 3:59 pm. For warrants over Hang Seng Index ("HSI"), the market value of a participant's holdings will be calculated based on the warrant bid price at 4:28 pm.
• After 8 weeks, there will also be one Category Hotshot Prize winner in each category. This will be the participant with the largest portfolio value in terms of credits from each category, regardless of when the participant joined the contest.
• After 8 weeks, there will be one Grand Hotshot Prize. This will be the participant with the largest portfolio value in terms of credits, regardless of when the participant joined the contest. Do note that the winner of the Grand Hotshot Prize will also be the winner of his or her Category Hotshot Prize, and could potentially be the winner of the Weekly Prize for the last week. However, only the cash value of the Grand Hotshot Prize will be awarded.
• The cash value for each of the prizes is stated below:
1. Grand Hotshot Prize: S$20,000 for the grand winner.
2. Category Hotshot Prize: S$3,000 per winner (total 3 winners)
3. Weekly Hotshot Prize: S$200 per winner each week (total 32 winners)
• Participants are allowed to win weekly prizes more than once.
• To be eligible for any prize, the following conditions must be met:
1. The Participant must have complied with the Rules & Regulations stated herewith
2. The Participant must have completed at least one buy trade (using the credits in the Hotshot Account) during the duration of the contest.
3. The Participant must not have been disqualified from the contest.
• In the case of a tie, the prize will be split equally among the relevant participants. For example, in relation to the Grand Prize, a tie for Grand Prize between two Participants means that both will share the cash prize of $20,000 equally between themselves i.e. S$10,000 each.
• All winners will be notified by mail at their registered address in Singapore. Prizes must be collected within a month from notification.
• If a participant's portfolio ranks among the top weekly or overall portfolios in each category in terms of performance, their registered name in their NRIC or Passports and/or their portfolio/holdings may be displayed on the contest website or in the newspaper. All Participants who win a prize shall agree to allow their names and photographs to be used in public communication medium such as, but not limited to newspaper, internet or television.

Trading Details

• Orders placed to buy or sell Macquarie warrants can be executed at any time of the day during trading hours (9:00 am - 12:30 pm, 2:00 pm - 4:59 pm). Participants will not be able to execute orders during the pre-open matching period (8:30 am - 8:59 am) and the pre-close matching period (5:00 pm - 5:05 pm).
• For warrants over Hong Kong underlying stocks, these will trade according to the Hong Kong market trading hours: 10:00 am - 12:30pm, and 2:30pm - 3:59pm. Participants will not be able to execute orders during the pre-open and pre-close matching periods also.
• For warrants over the HSI, these will trade according to the Hong Kong Hang Seng Index Futures trading hours: 9:45 am - 12:30 pm, and 2:30 pm - 4:28 pm.
• Price quotes for Hong Kong stocks will not be displayed on the contest website. There will be a link to take participants to the relevant webpage on the Hong Kong Stock Exchange website, where prices are quoted with a 15 minutes delay. However, the price quotes for warrants over Hong Kong stocks will be live.
• Quotes for HSI will not be displayed on the contest website. There will be a link to take participants to the relevant webpage on the HSI website. The price quotes for warrants over the HSI will be live.
• All orders for the day will expire if they are not matched by the end of the trading day. However, orders placed after markets close will be saved in the system and matched at the first minute after the respective markets open.
• Should a participant execute a large order, such as buying 1 million warrants on the offer when there is only 200,000 on the screen, the contest trading platform will execute the order in multiples of 200,000 with a 2 second lag e.g. Buy 200,000 warrants, and the next 200,000 warrants will be bought only after a 2 second lag. This feature attempts to simulate the real world, where issuers will replenish the volume on the offer at the same price in the warrants should the underlying share price not move and there is sufficient volume in the underlying for issuers to hedge their positions.
• Orders executed in the contest will be done immediately to simulate real time trading. However, participants should note that if the bid / offer quote in the warrant is $0.20 / $0.205, and if participants wish to buy the warrant and get their order filled immediately, they should pay the offer and buy the warrant at $0.205. If they choose to bid at $0.20, their order will be filled only when the warrant ticks down to $0.195 / $0.20.
• Participants can cancel or reduce the quantity of their buy and sell order if such an order has not been filled, i.e. in the 'Pending Orders' section.
• To increase the quantity of an order, a new order entry has to be made.
• Once an order has been filled, the order cannot be cancelled or amended.
• No odd lots may be traded. The minimum volume is set at 1,000 warrants or 1 board lot.
• Short selling of warrants will not be allowed. Participants can only sell warrants which they own, as there will not be a buy-in market for participants with overnight net short positions for the duration of the contest.
• In the event that an underlying stock is placed on a trading halt, the corresponding warrants will be placed on a trading halt in the contest.
• If an order is placed for a warrant whose underlying is on a trading halt or suspension, the order will not be processed until the trading halt or suspension is lifted.
• If a Participant holds a warrant whose underlying is on a trading halt or suspension, the warrant cannot be sold until the trading halt or suspension has been lifted. If there is a trading halt or suspension on an underlying stock at the end of the contest, the last quoted bid / offer price in the warrant before the trading halt or suspension will be used for the final valuation of the warrant.
• If an underlying stock is delisted on the SGX market, the corresponding warrants will be delisted in the contest.
• If a company and its corresponding warrants are delisted, a Participant's warrants will hold no value and its value will be removed from the Participant's portfolio.

Payments & Sale Proceeds

• There are no brokerage commissions, clearing fees, GST and any other miscellaneous charges in the simulated trading environment of the contest. Participants' profits and losses will be based on the capital gains and losses from trading the warrants.
• There will be no margin financing option in the contest.
• There will be no contra period for any warrants purchased. The payable amount will be immediately deducted from the participants' 'Cash Balance'.
• When submitting a buy order, there will be a check for sufficient funds (credits) in the participant's Cash Balance. Once a buy order is completed, the required amount will be immediately deducted from the participant's Cash Balance. If the order is rejected because the participant does not have enough 'Cash Balance', the participant needs to adjust the quantity of warrants or the limit price.
• When the participant's sell order has been executed, the sales proceeds will be immediately credited into the participant's Cash Balance. Under Realized Profit/ Loss, the participant can monitor the amount of realized profits or loss, if any.

Adjustments to Warrant Terms

• Ordinary dividends are incorporated into the price of a warrant so that on the ex-dividend date when the share price falls by the amount of the forecast dividend, the warrant price should not change.
• Special dividends, capital reduction and or any other corporate measures undertaken by a company may affect the price of the warrants. Macquarie will issue an official announcement on the SGX, stating the details of the adjusted strike prices and entitlement amounts on both the SGX website and Macquarie's Warrants Homepage. The adjusted strike prices and entitlement amounts will be automatically updated in the contest.

Investment Warrants

• Investment Warrants are a new type of warrant that Macquarie introduced to Singapore early in 2008. Different from conventional 'trading' warrants currently traded on the SGX, which typically have a contract expiry of three to six months, Investment Warrants have lower exercise prices and longer expiry dates, therefore giving them lower holding costs and a lower risk profile than conventional trading warrants.
• Investment Warrants allow investors to receive net ordinary dividend equivalent payments. Thus if a company declares a 50 cent net ordinary dividend, the investor will receive the full 50 cent equivalent payment if you purchase the proportionate number of Investment Warrants to entitle you to 1 underlying share. For example if you were holding an investment warrant with a warrants per share number of 10:1 and the underlying share announced a dividend of 50 cents, each warrant that you hold would be entitled to 5 cents (i.e. 50 cents divided by 10)
• On the SGX these dividend payments are distributed to the holder within 5 days of the dividend payment date. In the contest they will be credited to the investors account on the day of the ex-dividend date as the contest will only last eight weeks while the dividend paid date may be longer than the duration of the contest.
• Special dividends, capital reduction and or any other corporate measures undertaken by a company may be adjusted in the same way as a conventional trading warrant (see section above)

All the best to those who are participating in the contest.

Actual Operation of Warrant Trading (Part 4)

In this post, I’ll discuss a rather simple topic on the “Actual Operation of Warrant Trading”. This post will focus on the continuous quote of warrant trading. In Singapore, market makers provide liquidity to the market under a continuous quote system.

There are however under some circumstances that market makers will not be able to provide any quotation. The following is a list of such situations.

1. When the warrant is suspended from trading for any reason, including, without limitation, as a result of its underlying being suspended from trading;
2. In the event of the occurrence of a market disruption event, including, without limitation, any suspension of or limitation imposed on trading (including but not limited to unforeseen circumstances such as by reason of movements in price exceeding limits permitted by the SGX-ST or any act of god, war, riot, public disorder, explosion, terrorism or otherwise ) in a stock, or any warrant, option contract or futures contract relating to the stock;
3. When the issuer and/or the guarantor hold(s) less than 5% of the total issue size of the warrant (in which event, quotes will be for bid price only), that is, when the guarantor and its group of companies hold, in their proprietary position, less than 5% of the total issue size of the warrant, which, for the avoidance of doubt, shall exclude any unit of the warrant held by the guarantor and/or its groups of companies in a fiduciary or agency capacity;
4. During the period of five business days immediately prior to the expiry date of the warrant;
5. If the stock market experiences exceptional price movement and volatility, that is to say, during fast market; and
6. Where the market maker faces technical problems affecting the ability of the market maker to provide bid and offer quotations.

The most commonly seen situation is case 4 when the warrant is not tradable any more. I hope this post will give a rough idea to investors to the different situations why there are times when warrants do not have any quotes. In the next “Actual Operation of Warrant Trading” posting, I’ll be discussing about the calculation of warrant settlement price for both equities and index.

Actual Operation of Warrant Trading (Part 3)

This is the third part of the Actual Operation of Warrant Trading. In this post, I’ll discuss about the face value of warrant. Some investors prefer warrants with a smaller face value, because they cost less to buy and the tick value is lower, and they are more sensitive to the movement of the underlying price. However, other investors prefer warrants with a bigger face value, on the grounds that, with their higher tick value, one tick will be enough to pay the brokerage commission.

So, is it a better strategy to buy warrants with smaller face value or those with a bigger face value? Lets us find it out by comparing transaction costs and how closely the warrant price will follow the movement of the underlying price.

Let us start with transaction costs. Assume that the bid/ask spread of the warrants is one tick across the board. For a warrant with a face value of no more than S$1.00, say S$0.50, the tick value is S$0.005. This is also the minimum transaction cost for buying and selling the warrant, with the underlying price remaining unchanged. For another warrant with a face value within the range between S$1.00 and S$9.99, say S$5.00, the tick value of the warrant is S$0.01. It seems that the warrant with a bigger face value is more costly. In fact, this is not true. In percentage terms, the transaction cost is actually higher for warrants with a smaller face value. In the case here, the warrant with a smaller face value, S$0.005 / S$0.50 * 100 = 1%, compared with the warrant with a bigger face value, S$0.01 / S$5.00 * 100 = 0.2%. Hence, the trading risk is relatively lower for the latter.

Besides, a warrant with a smaller face value is more likely to follow closely the movement of its underlying. Say, we have two warrants, both with a delta of 0.05 and a conversion ratio of 10:1. For the one with a smaller face value, its tick value is S$0.005. When its underlying goes up by S$0.10, the warrant will in theory, climb by 1 tick (S$0.1 * 0.05 = S$0.005). As for the warrant with a bigger face value, its tick value is S$0.01. When the underlying goes up by S$0.10, the warrant will appear to be not moving at all, as the increase in its price is less than a tick (S$0.005 = ½ tick).

Face value may be more relevant to investors looking for fast money. For ordinary investors, it does not mean much whether it is S$0.005 or S$0.01 a tick. Of course, we always want to buy something at a lower cost if possible. Nevertheless, you are advised not to be too concerned with the tick value, but spend more time studying the terms such as effective gearing, to find out the most suitable warrant for your portfolio.

Actual Operation of Warrant Trading (Part 2)

This post is a continuation from where I stopped back in April. In this post, I will discuss about the bid/ask spread or in option trading world, it is commonly known as the slippage, of warrant trading.

Short term investors will find warrant trading attractive only if at least two conditions are satisfied. Firstly, there must be sufficient liquidity in the market so that warrants can easily change hands. Secondly, the bid/ask spreads must be narrow enough to keep transaction costs low. Since market making was introduced, liquidity is no longer a problem. Besides, as competition gets more and more intense, market makers are also maintaining their bid/ask spreads within a tight range. However, at times some warrants do trade with a rather wide spread. Well, then, how are bid/ask spreads determined?

The first factor to consider is delta. Given a conversion ratio of 1:1, the higher the delta (that is, close to 1 or 100%), the narrower the gap in the bid/ask spread between a warrant and its underlying. Let us say that the bid/ask spread of the underlying is S$0.02. If the warrant has a very high delta, it’s bid/ask spread will be close to S$0.02. However, if the conversion ratio is 10:1, the bid/ask spread of the warrant will be around S$0.002.

Let use an actual example to see if that is the case. The screen capture below shows the bid/ask price of some warrant with delta close to 100% on June 13, 2008. The next screen capture shows the buy and sell price of some counters from SGX on the same date. Noticed in the first screen capture, three out of the four warrants in the screen capture that are very close to expiration have delta close to 100%. This should be the case since the three warrants are deep ITM with around two weeks to expiration. The only warrant with a delta close to 100% and more than two months to expiration is DBS BNP ECW080905. We shall use this as an example.

Based on the second screen capture, the bid/ask spread of DBS is S$19.10 – S$19.06 = S$0.04 and the entitlement ratio is 8. This means we should expect the bid/ask spread of the warrant to be around S$0.04/8 = S$0.005. However, based on the first screen capture, the bid/ask spread for DBS BNP ECW080905 is S$0.535 - S$0.51 = S$0.025. This is 5 times more than what we expected. How about the theoretical bid/ask spread of a warrant? We can compute this by multiplying the delta of the warrant with the tick value of the underlying. Hence, the theoretical bid/ask spread for DBS BNP ECW080905 is 90.22% * S$0.02 / 8 S$0.002. Since the bid/ask spread of the warrant is also subject to the different tick values of different price ranges set by the stock exchange, we will expect the warrant bid/ask spread to be S$0.005 (the minimum bid size for price range up to S$0.99) which is consistent with the expected S$0.005 bid/ask spread we calculated earlier on. Hence we need to find out why is the actual bid/ask spread 5 times more than the theoretical spread? This will lead us to the second factor.

The second factor to consider is the liquidity of the underlying. Once a warrant is issued, the issuer has to make the necessary hedging arrangements. Buying some holdings of the underlying is one of the methods. If the liquidity of the underlying is inadequate, the cost of hedging will be high. Hence, issuers will work out an estimate of the size of the float of the underlying they can buy or sell at the optimal price before setting the bid/ask spread of the warrant.

In the case of DBS BNP ECW080905, the delta is 90.22% and the bid/ask spread of the underlying (DBS) is S$0.04; therefore the warrant bid/ask spread should be around S$0.005. Since the conversion ratio is 8:1, this means for every 8 units of warrant the issuer needs 1 unit of DBS share to hedge its position. The outstanding warrant as on June 13, 2008 was 50, 000, 000. This is shown in the screen capture below.

Assuming this value is accurate, this means that the accumulated overnight positions, held by investors rather than the issuer at the close of trading was 50 million units. This means if the issuer needs 50 000 000/8 = 6.25 million units of DBS shares to hedge its position since the listing of this warrant.

Let’s assume due to the insufficient liquidity in the market, the issuer can only buy 6 million units of DBS shares to hedge its position at optimal price says at its average price of around S$18.80, computed based on the closing price of DBS since beginning of this year. This means the issuer has to pay an extra cost for the remaining 0.25 million units of DBS shares. If the issuer needs to pay the price of S$19.00 to buy those units for hedging, the bid/ask spread of the warrant will widen to (19.00 – 18.80)/0.02 * 0.02 * 90.22% / 8 = S$0.023 or about 5 ticks more.

The above are only assumptions made for the purpose of discussion and may not be necessary be true. Of course, sometimes an issuer may want to maintain a narrow spread for a particular warrant. So if the investors can spend a little time to observe how different issuers deal with the bid/ask spreads of their warrants, it would not be difficult to compare them and choose the most appropriate warrant to trade.

Investment Warrants

I came across this special type of warrant few months ago and I find it was quite an interesting derivative instrument that is very different from the usual plain vanilla warrant.

From what I know now is that the only issuer for Investment Warrant is Macquarie. I have gathered some information from their website and re-posted it here. If you are interested to know more, there is an upcoming free seminar on the 18th June 2008 talking about Investment Warrant. You can register here.

Macquarie’s Investment Warrants allow you to get exposure to shares at a fraction of the price. With Investment Warrants you can:

• gain long term exposure for a fraction of the share price
• limit your capital at risk
• increase your effective dividend yield

Investment Warrants have longer expiry dates, lower holding costs and a lower risk profile than Trading Warrants. They are suitable for both short term and long term investment horizons.

If you recall the first post on Analysis of Warrant Data I posted in early January this year, you will notice the warrant name has an additional “I” to indicate that it is an investment warrant, e.g. COSCOCORP MBL ICW90403. Also note that by its definition, there is only investment call warrant and no such thing as investment put warrant.

What is an Investment Warrant?

An Investment Warrant enables you to buy shares in two payments. You pay a fraction of the share price up front and get exposure to the capital movements in the underlying share and all of the ordinary dividends over the life of the warrant.

Generally, the price of an Investment Warrant will move in line with movements in the underlying share and, because warrants are only a fraction of the price of the underlying share, they tend to move in greater percentages than the share price.

Investment Warrants also give you a payment equivalent to 100% of the ordinary dividends of the underlying shares. This is something that normal derivative instruments do not offer. Hence, in a way Investment Warrants therefore allow you to potentially earn a greater return than you might achieve by owning the share itself (see example below).

Investment Warrants give you:

• the right to buy a share
• at a specific price (called the exercise price)
• on a specific date (called the expiry date)
• the equivalent of 100% of the ordinary dividends throughout the life of the warrant

Investment Warrants are listed on the SGX so you can buy and sell them at any time, just like shares.

At the expiry of the warrant you have the option to either pay the exercise price and take delivery of the shares or simply receive the cash settlement amount (if any).

Benefits of Investment Warrants

• Greater return potential – through the effect of gearing, price movements are magnified
• Longer term exposure – lower holding costs mean Investment Warrants are suitable for both short and long term investments
• No Margin calls - increase your exposure to shares without the risk of margin calls
• Physical settlement – option to exercise and take delivery of the fully paid shares at expiry
• Enhanced Dividend Yield – holders receive the equivalent of 100% of the ordinary dividends of the underlying share for less outlay

Warrants enable investors to spend less up front, diversify their investments, potentially accelerate their growth and meet their investment objectives sooner.

Who would use Investment Warrants?

You might use Investment Warrants if:

• you are a long-term investor looking for a lower risk way to increase your investment returns
• you are a trader with a positive view on an underlying share and you want a moderately geared alternative
• you are an existing shareholder and want to unlock some capital from your portfolio by switching from shares into Investment Warrants

How Investment Warrants work

If you believe DBS shares will rise, you may wish to leverage your view by buying Investment Warrants over DBS shares. A hypothetical example is shown below:

Instead of purchasing the DBS share at $21.00 you can buy the Investment Warrant for only $7.30 to gain exposure to the performance of the DBS shares. During the life of the DBS Investment Warrant, the warrant price will tend to move up and down in line with the DBS share price. Investors may increase or exit their investment at any time by buying or selling the Investment Warrants on the SGX. The investor will also receive the equivalent of 100% of the ordinary dividends paid by DBS throughout this term.

At the expiry, if the investor is still holding the warrant they may either pay the exercise price of $15 and take delivery of the DBS shares or they can choose to receive the cash settlement value (if any).

• The cash settlement at expiry is calculated using the following formula:
  (Share price - Exercise price) x conversion ratio
• For example, if DBS is at $24 at expiry the warrant value would be:
  ($24.00 - $15.00) x 1 = $9.00

How gearing can boost your return

One of the main advantages of warrants is ‘gearing’, meaning a warrant provides the holder with an increased exposure to the underlying share. Therefore, a small percentage change in the price of the share can lead to a large percentage change in the value of the equity warrant.

The added advantage of Macquarie’s Investment Warrants is the increased effective dividend yield. The holder of an Investment Warrant is entitled to a payment equivalent to 100% of the ordinary dividends in the underlying share; however as the warrant price is only a fraction of the share price the effective dividend yield to the holder is increased.

Here is a hypothetical example:

It’s important to remember leverage works in both directions, so a fall in the share price would also cause a greater percentage fall in the value of the warrant. It is also important to be aware that Investment Warrants will expire worthless if the share price is at or below the exercise price at expiry.

Using Investment Warrants to release capital from your portfolio

Investment warrants are a convenient and lower risk alternative to release capital from your portfolio. If you have an existing share holding you can switch into a Macquarie Investment Warrant by selling the shares and buying Warrants. By doing so you will maintain exposure to the share movements and dividends while releasing capital for other investments.

Here is a hypothetical example:

Advantages of Investment Warrants over other financing facilities

• Ability to leverage above 70%
• Limited downside
• No margin calls

There is always some risks in any kind of investment may it be stock, plain vanilla warrant or option etc. Hence the same goes for Investment Warrant. Please do some homework and understand the risks and rewards of this new derivative instrument better before risking your hard earned money in it.

Actual Operation of Warrant Trading (Part 1)

It has been a really long time since I last blog. I am very sorry for my readers who visited my site and got nothing new to read. I was held up with a lot of things recently. Nevertheless, despite being busy, I have also been reading a lot on the Heston Stochastic Volatility Model and Model-Free Implied Volatility. I have dived a little more in depth on how to adjust a financial report to better value a company. There are simply too many things which I want to share as I read but I need some times to digest and further verify those things I read with real life examples before I share with my readers. As such, I have decided to continue another series of warrant trading posting but this time round, I’ll be posting on the actual operation of warrant trading.

In this posting, I’m going to discuss about the effect of tick value on warrants. With effect from 24th December 2007, SGX had revised the minimum bid sizes for its various financial instruments products. I am interested in the revised minimum bid size for securities. Under the new revised schedule, any securities trading below $1.00 have a minimum bid size of $0.005. Securities trading between $1.00 and $9.99 have a minimum bid size of $0.01. Securities trading $10.00 and above have a minimum bid size of $0.02. With this new revised minimum bid sizes in mind, I’m going to use Singapore Exchange (SGX) as an example for my discussion.

When SGX is trading at close to $10.00 in January this year, we can see that some of the warrants derived from it are lagging behind, while some others follow closely but with a bigger bid/ask spread. You can easily verify this by randomly looking at how closely the warrant price follows the stock price under the Data & Chart > Historical Price at SG Warrants. For easy reference, I have randomly capture three images for some SGX call warrants.

The examples I used here are not really perfect and one will be right to argue that there are some other factors (e.g. such as trading volume on that particular day) that causes the charts to be difference. Nevertheless, they are good enough to illustrate the point I’m going to discuss.

From the screen captures I have done, you will notice that for some warrants, the price of the warrant will follow very closely with that of the underlying stock while on the other hand, some of them do not follow as closely. Of course, for put warrants, the prices move in opposite direction of the underlying stock.

Assuming SGX is trading close to $10.00 at this point of time. The next tick will either bring the stock price up to $10.02 or $9.98. Hence, in this example here, a $0.02 change will mean a 0.2% increase or decrease in the underlying price. If the warrant has an effective gearing of 10 times, this $0.02 change in the underlying will be enlarged to a 2% (10 X 0.2%) change in warrant price.

Looking at another perspective, suppose we have a SGX warrant with a delta of 40% and a conversion ratio of 1:1, then for every $1.00 change in the underlying price, the warrant should, in theory, rise or fall by $0.40. So, for every $0.02 change in stock price, the warrant should move by $0.008 ($0.02 X 0.4). If the face value of the warrant is above $1.00, its tick value will be $0.01. For each tick ($0.02) of movement in the underlying price, the warrant will move by $0.008, which is not enough to make a tick in the warrant price. It appears that the warrant is lagging behind. However, if the warrant’s face value is below $1.00, its tick value will be $0.005. In this case, for every tick ($0.02) of movement in the underlying price, the warrant price will move by 1.6 ticks. Hence, if one goes for a warrant with a high delta and smaller face value, one may expect to see some movements in the warrant price.

In the face of technical issues, different issuers opt for different treatments. Some leave their warrants to swing up and down with the underlying securities, which indirectly increases the trading risk. Others take action to even out the fluctuations and make their warrants move up and down in an orderly manner (so that the warrant price will follow the underlying price to take on the ask side or the bid side). Still others choose to widen the bid/ask spreads of their warrants.

Investors should understand that there exist various technical issues in the market. We should not hastily jump to the conclusion based on the varied performance of different warrants that this or that issuer is not doing a good job. The truth may boiled down to the different treatments adopted by the issuers.

Analysis of Warrant Data (Part 8)

Today is the 29th of February 2008. I suppose you know this day only comes once every four years. This year is a leap year. I am not too sure if you know there is also something known as the leap century which occurs once every four hundred years. Something interesting about the leap century is that the 1st of January of a leap century always falls on a Saturday. You can easily verify this with a perpetual calendar if you are interested. The last leap year was 2004 and the last leap century was 2000. We have to wait for another four years till 2012 for another leap year and 2400 for another leap century. I do not think I will see that year coming.

Theta

In warrant, there is the effect of time as well and you do not have the luxury of another four years. The Greek used to measure time is known as theta. Theta, also called time decay, measures the rate of change in the price of a warrant as its maturity is running short while all other things being equal. It can be expressed as an absolute value or a percentage relative to the warrant price (theta / warrant price). Unless in some special circumstances, the value of theta is usually negative, reflecting the declining value of a warrant as time passes. The time decay has its greatest effect when the warrant is near to its maturity. Time decay accelerates as time passes.

In percentage terms, time value has the biggest impact on out-of-the-money (OTM) warrants. The value of a warrant consists of intrinsic value and time value. They vary in absolute and relative terms for warrants with different strike prices and maturity dates. In the case of OTM warrants, their intrinsic values are negligible or zero. In other words, time value makes up most of their values. Hence, they are more sensitive to the passage of time. As for the in-the-money (ITM) warrants, given that a large part of their value is made up of intrinsic value, they are less sensitive to the passage of time, and such sensitivity decreases as the maturity date gets nearer.

Investors should find out more about the theta of a warrant as a percentage relative to its price, that is, relative theta. The latter is a better indicator to the sensitivity of a warrant to the passage of time, and will give you a better idea about the effect of time value on the gain or loss on warrants you are holding.

Vega

Vega measures the rate of change in the warrant price for each point of movement of its implied volatility. No matter it is a call warrant or a put warrant, Vega is always positive, indicating that the warrant price and its implied volatility always move in the same direction. Vega can be an absolute value or a percentage relative to the warrant price.

In terms of the percentage change in price, changes in implied volatility have the biggest impact on OTM warrants. Besides, the closer they get to the maturity, the bigger the impact. Next come at-the-money (ATM) warrants, and then ITM warrants. For the latter, the closer they get to maturity, the smaller the impact. Hence, in picking warrant, investors should check out its Vega as a percentage relative to change in warrant price, in order to assess the impact of implied volatility on the warrant.

Gamma

Gamma measures the sensitivity of the delta of a warrant to the price movements of its underlying. The higher the gamma, the bigger the change in delta will be in reaction to a movement in the underlying price.

Gamma = rate of change of delta / rate of change of underlying price

No matter it is a call warrant or put warrant, gamma is always positive. When the underlying goes up, in the case of a call warrant, its delta will go up as it is more likely to be ITM; in the case of a put warrant, the same will happen too as it is more likely to be OTM and its delta will get closer to zero.

ATM warrants (for those with maturity of less than a year) have the highest gamma. This means that they have the highest rate of change of delta.

Rho

Rho measures the sensitivity of warrant price to changes in the market interest rate. Call warrants have a positive rho, meaning that the price of a call warrant moves in the same direction as the market interest rate. In contrast, put warrants have a negative rho, and this shows that the price of a put warrant moves in the opposite direction to the market interest rate. Given that changes in interest rates tend to be limited in the short term, their effect on warrant prices is minimal.

This is my last post on analysis of warrant data. What I have discussed above is known as the Greeks of warrant. They look quite similar to those of option. The Greeks are important in trading both warrants and options. Unfortunately, the information for the Greeks for warrants are not easily available as compared with options.

Analysis of Warrant Data (Part 7)

I went for a MSDN Tech-Talk held by Microsoft yesterday at One Marina Boulevard in the NTUC Auditorium. I was particularly impressed by the SQL Server 2008 that is going to be release soon in March. There is this Data analysis feature available since SQL Server 2005 and this is really a very powerful feature I would say. You can download a plug-in for Microsoft Excel 2007 and made used of this data analysis feature that comes with the developer, standard and enterprise version of the SQL Server 2005 and 2008 to perform time series regression to forecast short term and long term trend of data available in either the SQL Server or Microsoft Excel 2007. The plug-in also allows you to generate a report formatted with visual cue that made interpreting the data much easier.

I will be testing out the feature once I can get the SQL Server analysis service to setup on my computer. Meanwhile in today’s posting, I am going to continue on the Analysis of warrant data. I have been busy preparing my CFA level II examination and hence have not been updating my blog as regularly. This is the second last post on Analysis of warrant data which I will talk about Delta.

Put simply, delta measures how much, in theory, the warrant price will move for a $1.00 change in the underlying price (For me, I treat this as the first derivative of warrant price, typical engineer thought). For investors, delta is meaningful in the following aspects:

Relationship between delta and ITM/ATM/OTM

Call warrants have a positive delta, which means that the underlying price and the warrant price move in the same direction. On contrary, put warrants have a negative delta, which means that the underlying price and the warrant price move in opposite direction.

The value of delta lies between 0 and 1 for a call warrant, and between 0 and -1 for a put warrant. When a call warrant is at-the-money (ATM), its delta should be around 0.5. This value will move closer to 1 in the case the warrant becomes deeper in-the-money (ITM), or closer to 0 in the case the warrant moves further out-of-the-money (OTM). For a put warrant, when it is ATM, its delta should be around -0.5. Likewise, this value will move closer to -1 in case the warrant becomes deeper ITM or closer to 0 in case the warrant moves further OTM.

Delta reflects the degree of probability that a warrant will be ITM at maturity. A far OTM warrant has a delta close to 0, indicating almost zero chance that it will become ITM at maturity. An ATM warrant has a delta of around 0.5 and there is about 50% chance that the warrant will become ITM at maturity. A deep ITM warrant has a delta close to 100%, and this means there is nearly 100% chance that the warrant will stay ITM at maturity.

Prediction of changes in the warrant price

In general, investors can use delta to predict how much the warrant is likely to move for a $1.00 change in the underlying price. Say, for example, UOB BNP ECW100319 has a delta of 0.7468 after market closed yesterday. The conversion ratio is 14.993. The closing price for UOB was $18.42 yesterday. If the underlying price goes up by $1.00, the warrant price should, in theory, rise by $1.00 * 0.7468 / 14.993 = $0.05.

In reality, when the underlying price goes up or down by $1.00, the warrant is unlikely to move by the exact amount suggested by its delta, which is not a constant, but a variable. It will vary along with the underlying price, implied volatility and days to maturity. For example, assuming that the underlying price remains constant, with its time value or implied volatility falling, an OTM warrant will see a decline in its delta while an ITM warrant will see a rise. Usually, investors focus only on the relationship between delta and changes in the underlying price, and neglect the effect of changes in the implied volatility and time value.

Besides, the price of a warrant is determined by the market, and will be affected by market sentiments, market making activities, and the outstanding quantity of warrant. Hence, warrant usually trade at a level different from the theoretical price suggested by its delta.

Finding out the number of units of the warrant to be bought

Investors can also use delta to roughly estimate how many units of a warrant should be bought to reap a potential return close to that from a given units of the underlying. For example, a certain investor is optimistic about the UOB counter and wants to invest with a smaller amount of capital. If the investor wants to get an exposure to 1000 shares of UOB stock, using the previous warrant as an example, the delta is 0.7468, the number of units of warrant the investor should buy is equal to 1000 (the number of shares) divided by 0.7468 (the delta of the warrant), that is, 1340 units.

Finding out the number of units of new warrant to be bought for switching

Besides, investors can also use delta to roughly estimate how many units of a warrant need to be bought for switching to maintain the potential return. If the warrant on hand is about to expire or is going further OTM, one should consider switching. To find out how to use delta to calculate the number of units of the new warrant that need to be bought to replace the old warrant in order to maintain potential return at the original level, we can simply divide the delta of the warrant we intend to switch with that of the warrant we are switching to.

For example, CAPITALAND DB ECW080616 and CAPITALAND DB ECW080616 A have a strike of $7.30 and $6.30 respectively. Both have a conversion ratio of 5:1 and same maturity date. At point of writing, CapitaLand has a price of $6.62. Hence CAPITALAND DB ECW080616 A is ITM and CAPITALAND DB ECW080616 is OTM. CAPITALAND DB ECW080616 A has a delta of 63.27% and an effective gearing of 5.08x while CAPITALAND DB ECW080616 has a delta of 43.11% and an effective gearing of 5.44x. We noticed that CapitaLand share price has been going up for at least the past two weeks and says we remain positive that CapitaLand will move further up in price for next two weeks. Hence we want to switch from CAPITALAND DB ECW080616 A to CAPITALAND DB ECW080616 since it has a higher effective gearing even though CAPITALAND DB ECW080616 A has a higher delta. Therefore, we need to buy 63.27/43.11 = 1.46 units of CAPITALAND DB ECW080616 for each unit of CAPITALAND DB ECW080616 A to maintain the potential return.

You may ask, since the potential profit remains more or less the same, why should be bothered with switching at all? Why should we pay the additional transaction costs for selling CAPITALAND DB ECW080616 A and buying CAPITALAND DB ECW080616?

The purpose of switching is to allow us to sell a warrant with a higher price for another warrant with a higher effective gearing so as to invest with less capital for better utilization of funds. We do not have to be bound by the switching ratio, but it will give us an idea about how many units of new warrant we should buy to maintain potential profit as the same level.

The examples given are for illustration purpose and not my recommendation. I have tried to use real examples to illustrate my points. I will be positing my last post on analysis of warrant data soon.

Analysis of Warrant Data (Part 6)

Time really flies. Today is the 7th day of Chinese Lunar New Year also known as 人日, which means it is the birthday of human beings. Therefore, I would like to wish everyone a happy birthday. This is part 6 of my posting on Analysis of Warrant Data. In this post I will talk about effective gearing and gearing.

The biggest appeal of warrant trading lies in the leverage effect. Investors only need to invest a small sum to earn a potential return or even higher than that from directly investing in the underlying. However, in picking warrant, investors often get confused with gearing and effective gearing. So, what are the differences between them? Which of them is more indicative?

Gearing

Gearing only reflects how many times the underlying costs versus the warrant. Its calculation formula is:

Gearing = Underlying Price / (Warrant Price * Conversion Ratio)

For example, the SPC call warrant, SPC RB ECW080526, has a gearing of 7.12 times at point of writing. Then an investment of S$1000 for the warrant will be equivalent to an investment of S$1000 * 7.12 = S$7120 in the underlying. However, gearing do not reflect the relationship between changes in the warrant price and in the underlying price. For example, both CAPITALAND MBL ECW080606 and CAPITALAND BNP ECW080606 have the same maturity on 6th Jun 2008, same entitlement ratio of 3:1 and approximately same implied volatility 44.65% and 46.17% respectively (I know the implied volatility is not really very close but this pair of warrant is one of the closest I can find to illustrate the effect of gearing).The strike price for the warrants are S$5.80 and S$5.98 respectively. The underlying price at point of writing is S$5.85. We can see that the warrant which is further out-of-the-money has a higher gearing of 10.54x compared with 9.51x. If an investor uses the gearing of these two warrants to work out their potential returns, they may be disappointed. The rate of increase/decrease in the warrant price relative to the underlying price is not the same as gearing. When the underlying price increases by 1%, CAPITALAND MBL ECW080606 with a gearing of 9.51x should ideally increase by 9.51% and CAPITALAND BNP ECW080606 with a gearing of 10.54x should ideally increase by 10.54% too. However, in reality, based on the data I have collected for the two warrants, CAPITALAND MBL ECW080606 increases by 20.59% while CAPITALAND BNP ECW080606 does not move a bid with the same price change movement in the underlying. We should look at the effective gearing.

Effective Gearing

Effective gearing reflects the relationship between changes in the warrant price and in the underlying price. Its calculation formula is:

Effective Gearing = Gearing * Delta

In the example I have chosen above, CAPITALAND MBL ECW080606 has an effective gearing of 5.42x while CAPITALAND BNP ECW080606 has an effective gearing of 5.52x. Then, other things being equal, for every 1% change in the underlying price, the warrant price will in theory move by 5.42% and 5.52% respectively. In my not so perfect example here, because the implied volatility for both warrants are difference which causes the warrant prices to be difference and hence the difference in Effective Gearing. In conclusion, when you invest in warrants, you should look to their effective gearing, not gearing, as a reference for their risk/return performance. Just remember that a high effective gearing can give you a higher leverage but it also means it will fall faster too when the market is in not in favor of your direction of your warrant.

Relationship between maturity and effective gearing

Maturity is negatively related to effective gearing. If we have two warrants with the same strike price but different maturity dates, the one with a longer maturity has a lower effective gearing than the other. This is because that the one with a shorter maturity has a lower time value, and thus a higher effective gearing.

ITM/OTM and effective gearing

Further OTM warrants have a higher effective gearing, because their gearing levels are higher. So, if we have two call warrants with the same maturity but different strike prices, the further OTM one will have a higher effective gearing.

One point that must be stressed here is that although the leverage effect is the biggest appeal of warrants as an investment instrument, one should never blindly go after high returns. While it is true that, generally, a higher effective gearing means a higher potential return, if you are too eager to chase after those OTM warrants which are about to expire, the risk involved can be unaffordable.

These warrants are usually less than one month away from maturity, with an over 10% gap between the strike price and the underlying price, which is extremely out of the money.

By now, most readers must have understood that one should look to the effective gearing to predict the size of change in the warrant price for every 1% change in the underlying price.

Yet, one should note that effective gearing can only reflect the theoretical change in the warrant price in response to a given amount of change in the underlying price in the near term. In fact, when the underlying price changes, the delta and gearing levels will change to, which in turn affect the effective gearing. Besides, the formula for effective gearing is based on the assumption that all other things being equal (such as implied volatility, interest rate and market supply and demand). Hence, in case these factors vary, the warrant price may fail to rise in the way suggested by the effective gearing even in the short term.

In general, premium and effective gearing go up and down together. So, a low-premium warrant has a low effective gearing, and the same goes for the opposite. In the case of a short term ITM warrant, although it carries a high delta, its effective gearing is low due to the high price tag and thus, a low gearing. Mind you, warrant trading is mainly about the leverage effect. When the effective gearing is too low, it does not mean much to invest in the warrant, which only gives you a slightly enlarged return when the underlying price moves. Yet, you are not facing less risk associated with the shortening maturity and changes in implied volatility. The risk and return are out of proportion. Besides, although such warrants have a low premium, they are not suitable for investors with a short term perspective. For a more appropriate strategy, you should first identify your target underlying and short list the relevant warrants with a comfortable effective gearing. Then, simply compare the candidates based on their implied volatility to select your right warrant.

I have been very busy this Chinese Lunar New Year and is unable to blog that regularly. I will be posting more regularly on my upcoming posts. :)

Analysis of Warrant Data (Part 5)

Hi my readers, I am sorry for not posting for awhile. I have been busy doing spring cleaning :) Now my room has once again regained its cleanliness. I am going to continue my posting on analysis of warrant.

There was an article on My Paper on the 1st of Feb 2008, which was last week, regarding option trading. I am not too sure if anyone had read about the article? In the article, there was a short mentioned about the yield curve, a methodology to peek where our economy is heading towards to in year 2008 and perhaps the next one to two years to come. In fact, last year November, I had a similar post to explain the shapes of the yield curves and its implication on the economy. That was one of the reasons I started to monitor the STI put warrants since beginning this year, but I did not trade any of them, at least not using real money. :(

Anyway, I am a novice and risk adverse investor and I do not want to jump straight into the market before I understand how warrants work for me. It is like learning how to drive. We all started on circuit then we moved on to the roads and once we are familiar with it, we can drive safely on roads. Thought that does not guarantee you will not meet up with any accidents (touch wood) but at least you are more cautious and know what to look out for. Hence I do encourage novice investors and traders who wish to trade warrants or stocks to start doing virtual trade and make it as real as possible. Once you are able to reap consistent profit from your virtual trading, then perhaps it is time for you to test out your concepts and skills in the real market. Just remember to minimize your losses and let your profits run.

I would like to continue to share what I have learnt so far in warrant trading. This post is about premium. Premium is a measure of how much the underlying price has to move for the warrant to break even if it is held to maturity.

The premium for a call warrant =

([Strike Price + Warrant Price * Conversion Ratio] – Underlying Price) / Underlying Price * 100%

Whereas, Warrant Price * Conversion Ratio is the cost of buying a warrant, and Strike Price + Cost component is the breakeven point of the warrant. In this formula, we first calculate the difference between the breakeven point and the underlying price and then divide it by the underlying price to find out the premium as a percentage.

Likewise, the premium for a put warrant =

(Underlying Price - [Strike Price - Warrant Price * Conversion Ratio]) / Underlying Price * 100%

For example, the recently listed UOB call warrant UOB BNP ECW100319 is trading at SGD$0.315 at point of writing, with strike of SGD$15.38 and a conversion ratio of 14.993:1. The underlying price is SGD$17.36 at point of writing, then the premium is

Premium = (S$15.38 + S$0.315 * 14.993 - S$17.36) / S$17.36 * 100% = 15.80%
Breakeven = S$15.38 + S$0.315 * 14.993 - S$17.36 = S$20.10

In other words, if the investor intends to hold the warrant until maturity, its takes 15.8% increase in the underlying price from its current level of S$17.36 to S$20.10 to breakeven. In this example, what we have is an in-the-money (ITM) warrant, and the underlying needs a modest increase in the underlying price to breakeven. In the case of an out-of-the-money (OTM) warrant, the underlying must make a bigger climb to reach the breakeven point.

To sum up, the premium only measures the percentage increase in the underlying price that will allow the warrant investor to breakeven upon maturity. It does not tell us whether the price of a warrant is too high or too low. Hence, unless you are prepared to hold the warrant until maturity, premium is not a relevant indicator for you.

Today is Lunar New Year eve, I hereby wish everyone 恭喜发财,万事如意.

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.

Analysis of Warrant Data (Part 3)

The Fed's surprise rate cut on Tuesday calmed investors a little but many were struggling to decide whether the move was a sign of salvation or of worse to come in troubled markets. Apple's disappointing results will also keep shares subdued. In fact at this point of time I am blogging, the futures of S&P 500, Nasdaq and Dow are down by approximately -20.25, -41.75 and -131 respectively. We seem to be experiencing a rollercoaster market and a good strategy to use in such a situation is to buy a call and a put to form a straddle. In that way, you reap profits when market goes either ways. What is the catch? Well, the catch is, the market must move significant enough for you to reap a profit. I will cover how we can form a straddle in one of my upcoming posts.

I would like to continue my posting on analysis of warrant data. If you have trade warrant before or you have read up on warrants trading or attended some warrants trading seminar, then I suppose you may have come across these terms such as conversion ratio, although it is also called the subscription ratio, the exercise ratio, the cover ratio, the entitlement ratio, the parity ratio, the multiplier, the set, or just the plain ratio. Whatever it is known as, this simply means the number of warrants required exercising into one share, or its cash equivalent and it could be any value.

In my post here, I will just use the term conversion ratio as a reference. The conversion ratio determines the number of warrants required for conversion into one share of the underlying stock or one point of the underlying index at maturity. For example, where the conversion ratio is 10:1 or 10 or 0.1 (1/10), depending how the issuers present their data, it means 10 units of warrants will be required to be exchanged for each share of the underlying stock.

The price of a warrant is determined by a set of terms. Even though some warrants may have the similar terms, their prices may vary. For example, two warrants may have largely the same strike price, maturity and implied volatility, but the price of one may be a few cents while the other a few dollars. Why so? Well, indeed, even for warrants with identical terms, their prices may vary hugely. This is due to their conversion ratios.

For example, STI 3300 SGA EPW080328 and STI 3300 BNP EPW080328 both have a strike price of 3300, same maturity at 28th March 2008 and approximately similar implied volatilities of 38.35% and 40% respectively at point of writing. Their conversion ratios are 590 and 1250 respectively and their last traded price are S$0.655 and S$0.315 respectively at point of writing.

From the example above, one should notice that the bigger the conversion ratio, the lower the warrant price. Although the last traded value of one warrant is approximately twice of that of the other, they are actually worth the same. If we look at STI 3300 SGA EPW080328 which has a conversion ratio of 590, one has to buy 590 units to get one share of its underlying stock upon conversion. In other words, the cost of getting one share of the stock is S$386.50 (590 x S$0.655) which is approximately S$390. In the case of STI 3300 BNP EPW080328, it has a conversion ratio of 1250 and the cost of getting one share of the stock here is S$393.80 (1250 x S$0.315) which is approximately S$390 too. Thus these two warrants are worth approximately the same. Their prices vary only in proportion to the difference in their conversion ratios and of course, in my not so perfect example here, the cost is a bit difference because of their different in implied volatility. Recall from my previous post on “Implied Volatility, Historical Volatility and Volatility Smile”, the lower the implied volatility, the lower the price of the warrant.

The point I am trying to get across above is that conversion ratio is insignificant as a performance indicator and should not be used as a reference for the price of the warrants. Instead one should look out for implied volatility as a guideline.

Psychologically, investors tend to prefer warrants with a lower price. After all, warrants of different price ranges do differ in tick movement. Accordingly, issuers have to make a choice on the conversion ratio. Yet, in theory, the difference in conversion ratio will not affect the price performance of warrants. If you understand the reason behind this, it may help enhance your chances of success.

In calculating the value at maturity and the effective gearing of a warrant at any time, the conversion ratio is always taken into account. When you are picking a warrant, do not be bothered with insignificant data such as the conversion ratio or premium. Unless you want to hold the warrant until maturity, these data should not be a matter of concern. Rather, to make sure that you are picking the right choice, you should check out carefully the other terms of the warrant, such as implied volatility and effective gearing.

I shall continue to post on warrant analysis soon.

Analysis of Warrant Data (Part 2)

I believed by now, most of you have noticed the Singapore market had tanked more than 10% (based on the STI index) since beginning of this year. If you have read my blog earlier on regarding the “Yield Curve for Bonds” and if you have understood what the inverted yield curves really mean, and if you have read up more on warrants, I believe you may have earn quite a lot from buying the STI put warrants. One of the put warrants I was monitoring has risen more than 50% in price since beginning of this year and another is most likely going to expired in-the-money (ITM) in another 10days time. Well I am not encouraging anyone to go jump in the market and buy the STI put warrants now. The STI index has shown some signs of reversal for the last two days and some put warrants have drop in price. Give yourself some times and learn more about warrants before you embark your journey to warrant trading.

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. :)