Things to note
- An actively traded warrant may not necessarily be a good buy and cheaper short-dated and deeply out-of-the-money warrants may not closely track movements in the price of the underlying asset.
- You should be aware of the credit worthiness of a warrant issuer. If the issuer becomes insolvent and defaults on its warrants, you will be considered as an unsecured creditor and will have no preferential claims to any assets held by the issuer.
Having walked through the four steps for choosing an appropriate warrant to match your strategy, you should also bear in mind the following key issues.
Credit worthiness of warrant issuers: Uncollateralised structured products such as warrants are not asset backed. In the event that a warrant issuer becomes insolvent and defaults on its warrants, investors will be considered as unsecured creditors and will have no preferential claims to any assets held by the issuer. Disclosure of issuers' credit risk and credit worthiness can be found in issuers' listing documents posted on the HKExnews website. Credit ratings of issuers are available on the HKEx website. If an issuer suffers a credit downgrade, it will be required to publish an announcement on the HKExnews website.
Hot warrants may not be good buys: Informed investment decisions should be based on the pricing, such as implied volatility and spread, and the terms of a warrant, rather than on any short-term active trading activities. In particular, high turnover on a low number of warrants outstanding in the market casts doubt on the true popularity of that warrant. You should also be able to distinguish buying and selling orders from the liquidity provider and other market participants. An actively traded warrant is not necessarily a good buy. Instead, you should compare the implied volatility of different warrants on the same underlying asset to identify less expensive ones. In general, a warrant with a lower implied volatility is relatively cheaper.
Be wary of short-dated out-of-the-money warrants: Some investors like to speculate on short-dated out-of-the-money warrants, probably because of their low prices and high gearing ratios. Unlike stocks, warrants have a limited life and their time value reduces quickly towards their expiry date. In addition, deeply out-of-the-money warrants are less sensitive to movements in the price of the underlying asset because such warrants are unlikely to become in-the-money on expiry. Therefore, the prices of short-dated and deeply out-of-the-money warrants may not closely correspond to movements in the price of the underlying asset (e.g. a call warrant's price may not go up even if the price of the underlying asset rises).
Leverage can hurt: A prime attraction of warrants is that they offer exposure to the underlying asset at a lower cost. Some investors tend to invest in high gearing warrants to leverage up changes in the price of the underlying asset. However, this gearing effect can work in reverse. A small change in the price of the underlying asset can lead to a substantial decline in the warrant price. Usually, in-the-money warrants offer low gearing, while out-of-the-money warrants provide high gearing. Make sure that the warrant you choose corresponds with your risk tolerance level. Remember, even though the potential gain of buying a warrant can be substantial, you can still lose your entire capital if the warrant remains out-of-the-money on expiry.
Gearing ratio can't predict warrant price movements: Contrary to some investors' expectations, warrant prices may not go up at the rate represented by the gearing ratio. This is because the gearing ratio may vary as the price of the underlying asset changes. In addition, the price of a warrant is always subject to changes in short-term demand for, and supply of, that warrant.
Set expected profit and loss levels: It is important to control risk. Taking into account the expected volatility and time to expiry of a warrant, you have to be very clear when to take a profit or stop a loss, or whether to close your position before the warrant expires. Be realistic when setting your target levels and, more importantly, act on your strategy.
Avoid overbuying: Holding too many warrants in your portfolio can expose you to undue risk. Indeed, it is important to set an appropriate limit on the proportion of your portfolio that is invested in warrants, based on your investment objectives and risk tolerance level. Review your portfolio regularly and avoid going beyond the predetermined proportion.
Find out how liquidity is provided: It is important that you can get in and out of a warrant position quickly at low cost. Every warrant issuer must appoint a liquidity provider for its warrants. You can find out the details of an issuer's commitment to provide liquidity in the listing document. These include the method (active quotes or responding to quote requests), the liquidity provider's broker ID, the maximum time to respond to a quote request, maximum spread, minimum lot size and the circumstances under which the obligation to provide liquidity will be suspended. The designated HKEx's website has the list of all the liquidity providers for all derivative warrants.
Look beyond warrant recommendations: Recommendations on warrants and trading strategies in newspaper columns, and on TV and radio programmes often do not take into account individual investors' personal circumstances. What's more, some recommendations are given by warrant issuers in their own sponsored programmes rather than by independent market practitioners. It is important to know the assumptions behind any investment recommendation; never rely solely on a recommendation when making an investment decision.