BT: Warrants trading: What you need to know

Warrants trading: What you need to know

IF THE experts are right, the current boom in this investment tool is far from petering out.

Sun, Dec 02, 2007 The Straits Times

IF THE experts are right, the current boom in this investment tool is far from petering out.
They say more and more market traders are jumping in, as well as investors looking beyond stocks and bonds to bolster their portfolios.

To get an idea of just how popular they have become, consider this: Warrants turnover on the Singapore Exchange has grown from zero in 2003 to about $3 billion a month now.

The number of active warrant accounts has also shot up more than tenfold, to 20,154 this June from 12 months earlier.

A key attraction of warrants is that they are cheap.

Warrants trade around 20 cents to 30 cents, so the minimum investment for one lot - 1,000 shares - could be as low as $200 to $300.

As with any instrument, money can be made and lost when trading warrants.

For example, say an investor bought a call warrant on stock X for 30 cents with an exercise price of $5. Also, assume the conversion ratio is one to one, which means one warrant can be converted into one share.

The current share price is $5.25.

If the investor holds the warrant to maturity and exercises it, he is effectively paying $5.30 apiece for the shares (30 cents warrant cost plus $5 exercise price).

If the price of stock X stays at $5.25, he will get back 25 cents, so effectively, he will lose five cents ($5.30 minus $5.25).

If the share price falls to $5 or below, he will lose just his investment capital of 30 cents, but no more, even if the share price falls drastically.

On the other hand, if the stock's market price shoots up to $5.35, converting the warrant into a share would mean a five cent profit.

Consultant Peter Ang, 32, started trading warrants this year with a principal sum of $15,000.
He made a 25 per cent return in just three days, after he bought DBS Group Holdings and CapitaLand warrants in September.

But he lost about $20,000 in two weeks when the stock market nosedived recently. 'I wasn't careful, so I didn't cut my losses fast enough,' he said.

Despite the spectacular growth in the Singapore warrants market, Hong Kong is still well ahead because of a flood of China listings there.

Previous attempts to launch warrants trading here in 1995, and again in 1999, tanked for various reasons - including overly stringent listing rules and inadequate investor education.

But three years ago, warrant issuers - some of the biggest players include Deutsche Bank, Macquarie Bank, Societe Generale and BNP Paribas - started to double as market makers.

This means these banks provided buy and sell prices on warrants to ensure that investors had the chance to enter or exit the market.

They also embarked on investor education seminars and dedicated websites featuring trading tools.

How to pick a suitable warrant?

Directional view

Without getting bogged down in technical terms such as 'implied volatility', you should consider one factor when picking a warrant: whether you think the underlying asset is likely to go up or down in value.

Your view will determine whether you select a call warrant or a put warrant.

For example, suppose the Government has announced a new project and the likelihood of CapitaLand securing the project is high.

If you think this is good news for CapitaLand, you could consider buying call warrants on the stock - since you would expect the stock price to rise.

But if you think CapitaLand's share price is more likely to fall, you might want to buy a put warrant.

'Theoretically, if one has a neutral view on a stock, it would not be advisable to invest in warrants,' Deutsche vice-president Sandra Lee cautioned.

Timing

You also need to factor in the timeframe - and be confident that the underlying asset price is set to reach your price target at the same time that the warrant matures.

Take a call warrant, for example. The longer the time to expiry, the more time there is for the underlying asset to appreciate, which in turn will increase the price of the call warrant.

A call warrant that is far 'out-of-the money' with very little time to expiry is considered highly risky. This is because it has an exercise price that is much higher than its underlying price and yet has little time to appreciate.

In contrast, when the call warrant's exercise price is lower than its underlying price, the warrant is regarded as 'in-the-money'.

For both call warrants and put warrants, if the exercise price is equal to the underlying price, the warrants are said to be 'at-the-money'.

'If you believe the market is going to have a sharp correction soon, you should choose a short-term out-of-the- money put warrant,' said Mr Simon Yung, BNP's head of retail listed products sales for Singapore and Hong Kong.

'If you expect a stock to move up gradually in one to two months' time, you should choose a mid-term at-the- money or a 1 to 5 per cent out-of-the- money call warrant.'

Why invest in warrants?

Gearing effect

The biggest advantage warrants trading has over stocks trading is the gearing effect, which means that you can make huge gains from a modest investment outlay.

For example, it can cost nearly $20,000 to buy one lot of DBS shares (assuming a market price of $20 a share).

An increase of 1 per cent in the DBS share price will give you a return of $200.

But if you buy a DBS warrant with an effective gearing of 10 times, it should roughly return the same profit of $200.

The effective gearing indicates roughly how many per cent a warrant price will move if the underlying stock changes by 1 per cent.

In this case, trading in the DBS warrant costs just $2,000 but reaps the same $200 return.

'If the share price moves in your favour, you will get higher returns with a higher level of gearing. But if you get your view wrong, losses will also be greater,' said Mr Barnaby Matthews, Macquarie's head of warrants sales.

Since warrants are typically cheaper than underlying shares, this potentially frees up investors' cash for other purposes.

A hedging tool

Buying a put warrant - which gives you the right to sell the underlying asset later - is like buying an insurance policy for your portfolio, as it protects you from falls in the market.

'If the underlying asset declines, then put warrants will appreciate in price to offset losses suffered by the underlying asset,' said Mr Ooi Lid Seng, Societe Generale's vice-president of structured products for Asia ex-Japan.

For example, one can hold OCBC Bank shares and buy OCBC put warrants. If the OCBC share price keeps falling, losses will be partially offset by the gain in the put warrant price.

As warrants can be used to capture both the upside (call warrants) and the downside (put warrants), they can be used as a tool for risk management in a stock portfolio.

Mr Yung said that warrants can be a perfect instrument for balancing a portfolio's risk profile. 'A portfolio with only bonds, property and stock may not be able to optimise the risk-taking capability of the investor,' he said.

Tips on investing

FIRST, investors should never invest all their investment capital in warrants.

'Generally, we do not advise them to invest more than 10 per cent of their total investment capital in warrants due to the high-risk and high-return nature of warrants,' Mr Ooi said.

Retirees should also not use retirement funds needed to maintain their lifestyle to invest in warrants, as they generally have a lower risk tolerance, he added.

Investors should also be disciplined about taking profits and cutting losses. Mr Matthews advised investors to monitor their positions closely as warrants tend to move in greater percentage terms than shares.

Customer service manager Jason Kua, 37, would know. Three weeks ago, he lost about $25,000 in just two weeks after trading in some Straits Times Index warrants.

'Greed made me lose a lot. I was hoping my initial losses could be recovered, but this didn't happen,' he said.

Finally, investors should attend a seminar or do some reading to ensure that they understand the product before investing.

'Asking the expert before you invest is always a good idea,' Mr Yung said.
gabrielc@sph.com.sg

What is a warrant?

WARRANTS are 'derivative' investment products - that is, they derive their value from an underlying asset such as a stock or a market index such as the Straits Times Index.

They give the investor the right to buy or sell the underlying asset from the issuer by paying a specific 'strike' or exercise price within a certain timeframe.

A call warrant gives the holder the option to buy, while a put warrant gives the option to sell.

Take a Keppel Corp call warrant for example.

If the price of the underlying Keppel stock rises above the exercise price before the expiry of the warrant, it will clearly be to your advantage to exercise the right to buy Keppel shares.

If you plan to exercise the Keppel warrant - that is, convert it into a Keppel share - you must do so before the expiration date. Of course, if Keppel's price stays below the exercise price, the warrants will expire worthless.

But investors often do not have to hold warrants to maturity. Normally, they simply buy and sell warrants on the stock market as they move in line with movements in the underlying share price.

'Warrants, unlike shares, have a finite lifespan,' said Deutsche Bank vice-president Sandra Lee. 'For each day the investor holds on to the warrant, the warrant loses some time value.'

Warrants usually have three- to six-month expiry dates.