Choosing a warrant
Stock investing is rather straightforward. In most cases, there is normally one class of shares for each listed company. You choose a company and then buy its shares. That's it.
The story becomes intricate when you choose warrants. There can be a series of warrants on the same underlying asset, which may be provided by different issuers and carry different terms.
What is the ABC of warrant trading?
Step 1: Choose the underlying asset
The underlying asset of a derivative warrant can be a single stock, a basket of stocks, an index, a currency, a commodity, a futures contract (e.g. oil futures) etc. Presumably, you should only be interested in something that you know well.
Step 2: Take a view on the future price movement of the underlying asset
Do you expect the underlying asset price to go up or down? To what extent? In short term or long term? Will the future price movement affect you? Remember, a warrant is only a tool for you to benefit or avoid losses if your expectation on the future price movement of the underlying asset comes true.
Step 3: Choose an appropriate warrant to match your strategy
Take a look of the existing warrants on the underlying asset you select. Make sure that the warrants you pick match your view on the future price movement of the underlying asset. Choose call warrants if you believe the underlying asset price will go up, and pick put warrants if you think the price will fall. To hedge against the downside risk of an underlying asset that you hold, choose put warrants.
After figuring out the direction, screen out those warrants with the appropriate exercise price and time to expiry to match your expectations on the magnitude and timing of the price movement. For example, you may consider choosing warrants with a longer time to expiry if you don't expect a significant price movement in short term.
Step 4: Compare implied volatility to look for cheaper warrants
To evaluate whether a warrant is expensive or cheap, you should focus on its implied volatility, not on the warrant price and premium. The implied volatility of a warrant enables you to assess the relative expensiveness of a warrant. This is particularly useful if you are trying to compare warrants of different terms. In general, among different warrants on the same underlying asset, a warrant with a lower implied volatility is relatively cheaper. Many newspapers, financial websites, information vendors and warrant issuers carry information on implied volatility of individual warrants for investors' reference.
Implied volatility is not a constant. Changes in implied volatility could sometimes overshadow changes in the underlying asset price, particularly if the movement of the underlying asset price is very small. A drop in the implied volatility of a highly priced call warrant might offset the expected rise in the warrant price due to a rise in the underlying asset price, or even cause a drop in the warrant price. The following hypothetical example regarding a call warrant A helps to illustrate what might happen if the implied volatility of a warrant drops vis-a-vis a rise in the underlying asset price. Although the underlying asset price rises from $4 to $4.2, the price of warrant A drops from $0.8 to $0.75 mainly because the implied volatility decreases from 43% to 36%.
|Day||Underlying asset price||Implied volatility||Theoretical price of warrant A assuming no change in implied volatility||Theoretical price of warrant A assuming no change in underlying asset||Market price of warrant A|
Clearly, a highly priced warrant is more vulnerable to a downward adjustment in its implied volatility. As such, comparing implied volatility of various warrants helps you make a better decision in choosing warrants.
Can I use premium to find out cheaper warrants?
Some people prefer using premium as their benchmark for choosing a warrant. This could be misconceived. While premium is easier to be calculated and would give a sense of the expensiveness of a warrant, it is not designed for comparing warrants of different terms.
In general, an in-the-money warrant usually has a lower premium while an out-of-the-money warrant usually commands a higher premium. This is because of the gearing factor. Besides, a warrant with a longer time to expiry usually commands a higher premium than a warrant with a shorter life. If you want to compare warrants of different exercise prices and time to expiry, you might be at a crossroad to assess which one is cheaper.
For example, suppose that the following hypothetical call warrants B and C have the same underlying stock with different exercise prices and time to expiry. Although warrant B appears to have a lower premium than warrant C, but it does not mean warrant B is necessarily cheaper. In terms of implied volatility, warrant C is cheaper than warrant B.
|Warrant name||Warrant price||Exercise price||Months to expiry||Premium*||Implied volatility|
* Assuming the underlying stock price is $16 and the conversion ratio is 1.
What else to consider?
After all, given there may be warrants of different structures being offered on the same underlying asset, while choosing a reasonably priced warrant is important, you need to ensure that the warrant you choose also satisfies the direction (i.e. call or put), time to expiry, exercise price and effective gearing criteria. You should also take into account the reputation of the warrant issuer and how liquidity is provided (e.g. whether quotes with narrow spreads are always provided? How responsive to quote requests?) Always remember to exercise your own judgement: Whether a higher implied volatility is justifiable? Whether a cheap warrant is really worth buying?