How to select a Warrant

• View on Underlying Share/Index

  When choosing a warrant, we suggest that investors consider the following 4 steps:

  • View on Underlying Share/Index
  • Timeframe
  • Gearing Level
  • Implied Volatility

  To choose a warrant you should first look at the nature and performance of the underlying share/index and take a view. Bullish investors may consider a call warrant while bearish investors may consider a put warrant.

  

  In this first step, you also need to have a target price for the stock in mind. This will help you to narrow your selection of the warrants.

  

  Are you bullish (call) or bearish (put)?

  Warrant	Call/Put	Strike($)	Expiry Date	Warrant Price($)	Effective Gearing(x)	Implied Volatility(%)
  Warrant A	Call	2.25	03-Jan	0.320	5.9	30
  Warrant B	Call	2.80	01-Feb	0.090	9.0	27
  Warrant C	Put	2.60	02-May	0.270	4.6	29
  Warrant D	Call	2.60	01-Jul	0.270	3.8	37
  Warrant E	Call	2.55	04-Jul	0.220	6.9	22
  Warrant F	Call	2.70	04-Jul	0.100	9.3	21

  In the second step, think of how long you expect to be holding on to your warrant position. You also need to consider your risk tolerance. For example, if you are someone with a low risk tolerance and intend to hold on to your positions for a month, you might select a warrant with expiries of 2 months or more to give yourself some buffer. If you are someone with a high risk tolerance, you might select a shorter dated warrant to benefit from the increased leverage.

  

  A word of caution however on shorter dated warrants, a warrant that is approaching expiry (say with only 1 month or less to expiry) will decay at a high and increasing rate (for more information on time decay click here). So, while you can often earn a higher return on these warrants if your view is right, you are also taking on a higher risk as the warrant price will quickly decay in value. You must be very nimble when trading short dated warrants.

  What is your timeframe?

  Warrant	Call/Put	Strike($)	Expiry Date	Warrant Price($)	Effective Gearing(x)	Implied Volatility(%)
  Warrant A	Call	2.25	03-Jan	0.320	5.9	30
  Warrant D	Call	2.60	01-Jul	0.270	3.8	37
  Warrant E	Call	2.55	04-Jul	0.220	6.9	22
  Warrant F	Call	2.70	04-Jul	0.100	9.3	21

  An effective gearing of 5 times means a 1% move in the share price translate into an approximate 5% move in the warrant. The higher the effective gearing, the greater your potential returns. However, should your view be wrong, your losses will also be higher. Therefore, investors need to decide the level of gearing they are comfortable with. Click here for more information on effective gearing.

  

  For information on how the expiry date and gearing level interact to determine risk levels for a warrant, click here.

  What is your Risk Appetite?

  Warrant	Call/Put	Strike($)	Expiry Date	Warrant Price($)	Effective Gearing(x)	Implied Volatility(%)
  Warrant D	Call	2.60	01-Jul	0.270	3.8	37
  Warrant E	Call	2.55	04-Jul	0.220	6.9	22
  Warrant F	Call	2.70	04-Jul	0.100	9.3	21

  Finally, with the list of warrants narrowed from the first three steps, you should look at the implied volatility of the warrants in the list. All else constant, you would generally select the warrant with the lowest implied volatility. If you have two warrants with the same exercise price, expiry date and conversion ratio, a higher implied volatility in one warrant will translate to a higher warrant price.

  Implied Volatility

  Warrant	Call/Put	Strike($)	Expiry Date	Warrant Price($)	Effective Gearing(x)	Implied Volatility(%)
  Warrant D	Call	2.60	01-Jul	0.270	3.8	37
  Warrant E	Call	2.55	04-Jul	0.220	6.9	22

• Market Maker

  The quality and reputation of the market maker is also an important consideration when choosing which warrant investing in. You need to be confident that the market maker will be there to provide consistent pricing throughout the life of the warrant so that you can enter/exit the trade in a fair and liquid market.

  Macquarie has a leading market share in the local warrant market and much of this success is due to the quality of our market making, something we are very proud of.

  

• Risk Matrix

  The chart below summarizes how the expiry date of a warrant and its gearing level affects the risk level of the warrant.

  

  Generally, the shorter dated the warrants, the higher the risk of the warrant as there is less time remaining to reach your target price.

  Warrants with higher gearing also carry higher risk as they require a larger movement in the underlying price for the warrant to have value remaining at expiry, indicated by OTM (out-of-the-money warrants) in the matrix.

  Warrants with longer time to expiry and those that are deeper in-the-money (ITM) in the matrix are generally regarded as lower risk. Warrants that have further expiry dates allow more time for stocks to reach the target price and hence less time decay, while ITM warrants have lower gearing levels.

  It should be remembered that the higher the risk typically translates to a higher potential return and vice versa.

• Tips and Tools

  warrants.com.hk has a selection of very useful tools that will assist in your warrant selection process and also in your subsequent decision on when to sell. Here are a brief summary of some of these:

  Warrant search

  Allows you to search for warrants by specifying your criteria, it will display all of the important info you need to make your decisions. Click here

  Warrant terms

  Lists all of the current pricing information for a particular warrant. Can be accessed directly or via clicking on a warrant code in the warrant search table. Click here

  Compare warrants

  Allows you to select two warrants and compare their details side by side. Click here

  Moneyflows

  Will allow you to see which underlyings other investors have been buying and selling warrants over, giving you a feel for the market 'flows'. Click here

  Warrant calculator

  Allows you to change the variables of a warrant and see the resultant effect on the warrant price. Click here

  My Portfolio

  Here you can build a watchlist or a portfolio to track the performance of your warrant positions. You can even set up alerts to warn you of certain market events, like price change, etc. Click here