Structured Warrants - Basic Trading Strategies I - Part 5

We have covered the basics of structured warrants in the previous four articles. The next two articles, starting with the current, are crucial in determining how you could play the warrant trading game. Bear in mind there will be no perfect strategy to employ, based on wide base of risk preferences, market & stock views, and trading ideas from a vast spectrum of investors and traders. Thus, instead of trying to even suggest the optimal trading strategy, let is explore all employable strategies and required techniques and disciplines. In this article, we will look at three broad trading strategies, and three simple trading axioms to live along with.

 

Basic Strategies: The three basic strategies for using structured warrants are: (1) speculation; (2) hedging; and (3) cash extraction.

 

Speculation: If one could draw a parallel between the stock market and a casino, then using structured warrants can be viewed as an aggressive punt in a casino. It sounds like an adrenalin rush for day traders, but warrant trading can be systematically executed in taking a short-term directional view. The most important premise that justifies this strategy is the "unlimited upside, limited downside" feature of structured warrants. Recall that although warrants can potentially multiply both gains and losses (the effective gearing concept), investors or traders alike can only lose the price of the warrant (actually it is contradictory to include investors in this strategy, but we do have investors who want to time the market). Generally the cost of a warrant is significantly lesser than the price of the underlying share. This makes structured warrants a near-perfect replacement for penny stocks. Combine this with market variables in tight bid-offer spreads and low transaction costs and commissions, speculators could capitalise on short-term views based on their own guile, methodology and judgment. The most savvy of these traders trade for upsurge in volatility (means buying call warrants before the underlying stock undertake a huge move up), low delta and high effective gearing, and minimise time decay via short holding period (many are intra-day positions). The deployment of this strategy is based on gearing, but the golden rule underlining speculation is always about balancing greed and fixation. Be warned that it a leveraged directional bet - so if the directional view is wrong, learn to cut loss.

 

Hedging: For high networth investors, over-the-counter options are often structured by private banks to help them hedge against short-term volatility and uncertainties. In the same way, warrants could be used as a form of insurance to protect an existing share portfolio against a falling market. Put warrants allow the investor to retain share ownership without realising capital gains and without having full exposure to the downside risks. For the laymen market participants, however, hedging via structured warrants became more of a theoretical portfolio possibility than a practical application. First, few investors could comprehend the contradiction of hedging short-term volatility (say buying put warrants) against their longer-term portfolio view. Second, there are structural issues - such as the lack of script-borrowing facilities for hedging and short-selling constraints. These are factors contributing to the fact that the warrant market typically lacks the breadth of put warrants available for hedging purposes. Third, the portfolio hedge is a dynamic process. In a delta-neutral hedge, the investor has to work out X number of warrants with a certain delta to create a position that totally neutralise the potential loss in his share holdings. If he is holding 10,000 shares, he needs 25,000 put warrants with a delta of 0.4. If the share price falls by 50 sen, his portfolio will decline in value by RM5,000, but the put warrants will be trading 20 sen higher (0.4 of 50 sen). 25,000 put warrants will totally negate the loss. However, in practice, the delta changes so fast that periodic adjustment or rebalancing is required to maintain such a perfect hedge. This is reminiscent of the concept of gamma – rate of change of delta. If the gamma for the put warrant is high, the hedging process will be extremely tedious.

 

How about using a call warrant to hedge? Sure. An investor interested in purchasing shares who does not have immediate access to funds could purchase call warrants to capture the benefits of an anticipated price rise. This would allow the investor to establish a price (the exercise price) at which to purchase the shares in the future.

 

Cash Extraction: Call warrants could be used to free up capital invested in shares. This defensive strategy is often overlooked in a volatile market. An investor may sell existing share holdings and purchase a corresponding number of call warrants for a fraction of the price. He thus has maintained exposure to share price rises while releasing capital from the security holding. Gearing in this case means maintaining market exposure while limiting total capital risk. Again, as with the hedging strategy, the cash extraction strategy means a dynamic approach is required.

 

Two of the major drawbacks of the cash extraction strategy are loss of dividend/corporate exercise rights and time decay. Investors holding warrants do not receive the dividends paid on the underlying shares, nor or do they directly participate in rights or bonus issues. However, in valuing warrants, issuers estimate the expected dividend stream of the underlying shares. This means that call warrants should not dramatically fall in price when the underlying share trades ex-dividend. Similarly, put warrants used in the hedging strategy will not substantially increase in price. Generally, in the case of a rights or bonus issue, the terms of the warrant are adjusted so that the warrant holder will not be disadvantaged.

 

Afterthoughts: Whichever strategy an investor or a trader choose to employ, three principles of warrant trading need to be reminded and guarded vehemently.

 

First, know when to cut loss. A stop-loss discipline is the single most integral part of a warrant trader’s mindset. Because of its leveraged nature, warrants are double-edged swords in any portfolio, regardless of timeframe. Even if a successful warrant trader have been rolling over few series of warrants (higher and higher strikes) to maintain reasonably low delta and high effective gearing, cutting loss at any time simply means the trader has minimised downside risks while locking in early profits. While it could be true that the cut-loss view might be wrong, in that the share/warrant might reverse and surge over the next few days, holding on to the warrants and see it trending down towards zero is a much more painful process. In many cases, the notional of the warrants became so small that the settlement amount could not even cover brokerage costs.

 

What level to set the stop loss? Follow the technical analysis of the underlying stock. For instance, a bullish candlestick formation might trigger a long position, but a tightening of a Bollinger band might mean tighter trading range to be expected and thus warrant a cut-loss or take profit position. The most disciplined trader will use a trailing cut-loss strategy – cut-loss points trailing the stock as it gets higher. It is not an exact science, but it is extremely logical in the realm of structured warrants. Also remember – it is a momentum instrument – cut loss when the underlying stock is trading flat. Time decay will erode the warrant’s value day by day.

 

Second, do not average down a losing position. If an investor has bought some warrants at 40 sen, and the warrant inexplicably falls to 35 sen, it makes more sense to cut-loss than to average down. Warrants are not stocks – they have limited lifespan, and always be reminded of time decay. The issue here is that the market is a vast mass of collective sentiment of which any investor’s view is not even a drop in the ocean. A warrant heading down is doing so for a very good reason. Wrong view? Bite the bullet and cut loss, instead of digging a bigger hole.

 

Third, no one ever went broke taking profits. As mentioned in the previous article, one way to circumvent time decay is to hold a short term trade for any warrant, and roll over to another warrant with ample time value. For instance, in a trending market, the investor could have bought a 9-month warrant in January, roll it over to another 9-month warrant after in April, and repeat the process in July. There are two critical aspects in this strategy – that the investor moderates the time decay while maintaining leveraged market exposure, and that the investor renew the strike target every 3 months, thereby maintaining efficient effective gearing ratio and locking-in gains from intrinsic values in the process. This beats holding a single warrant across the entire lifespan. Inherently, this strategy "locks up" profits along the way.

 

Our next issue will be the last in the series. We will discuss more on trading discipline underlining warrant trading strategies.