Non-collateralized Nature of Structured Products
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Warrants Guidebook
Market Makers
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Liquidity vs Volume
The role of a designated market maker is to provide liquidity in the warrants by providing continuous buy and sell quotes. In doing so, the market makers provide liquidity in the warrants so that investors can easily enter and exit their trades. The quality of the market maker is often a big factor for investors choosing a warrant.
Bid Volume Bid Price Offer Price Offer Volume Underlying 200,000 $32.50 $32.75 200,000 Bid Volume Bid Price Offer Price Offer Volume Warrant 400,000 $1.43 $1.44 400,000 Typically a market maker will use the AMS/3 (Automatic Order Matching and Execution System) to enter their quotes. There are a few exceptions to the continuous quoting requirements, these can be found in the listing documents. The most common being, when the warrant value falls below S0.01, it is considered worthless and the market maker is no longer required to provide quotes.
A common misconception regarding liquidity is that only warrants with high traded volume are liquid. In the below example, we demonstrate that this is often incorrect.A look at Warrant Liquidity
Warrant A
Bid Volume Bid Price Offer Price Offer Volume Traded Volume 500,000 $0.045 $0.050 500,000 6,200,000 Warrant B
Bid Volume Bid Price Offer Price Offer Volume Traded Volume 500,000 $0.100 $0.105 500,000 200,000 The above tables show similar warrants A and B listed over the same underlying share. Warrant A is an actively traded warrant, with 6.2 million in volume for the day, while Warrant B has only 200 thousand traded. Some investors may assume that Warrant B is illiquid and avoid trading this warrant.
In actual fact, the liquidity for both warrants is very similar as both have the same number of warrants on the bid and offer for investors to enter and exit their trade. The liquidity of a warrant is more a function of the volume provided on the bid and offer by the market maker, rather than the number of times a warrant has actually traded.
Investors choosing which warrant to buy should first consider our suggested selection process. Do not choose a warrant based only on its turnover as this may not be the right warrant for you. The quality and reputation of the market maker is also very important. -
How we hedge
Before addressing this, let us first cover a long-lived misconception. Many investors think that issuers aim to make profits at the expense of investors. Meaning, if an investor buys a warrant for $0.1 and sells it back to the issuer for $0.08 the issuer makes a $0.02 profit. This is simply not correct and in fact, Macquarie would prefer investors to make money trading their warrants, so that they keep coming back to buy more warrants!
The aim of issuer is to capture profit on the risk management of warrants sold. When issuers sell warrants, they will normally buy shares or other derivatives to 'hedge' their position and attempt to capture a 'margin' whether warrant prices go up or down.
For example, if an issuer sells a call warrant they will often go into the underlying market and buy the underlying shares to 'hedge' themselves. Thus, if the share price increases, and investors profit on their call warrants, the issuer will also gain on their share holding. Warrants are not a 'zero sum game'.
What an issuer is really attempting to do is to hedge against changes in 'volatility', rather than the 'direction' of the shares.
The volatility of a share, simply put, is how much a share price moves up and down and is expressed in a percentage: the lower the percentage figure the less volatile the share is, the higher the more volatile. This volatility level is a key parameter in determining the price of all options and warrants.
Issuers use this percentage to measure the value of options and warrants and when considering which options to buy as a hedge against the warrants they have sold. If they have sold a warrant that has an 'implied volatility' level of, say, 25% and they can then buy another option of similar terms at, say 23%, they would theoretically be making a 'margin', or profit. In essence, this is how issuers attempt to profit rather than 'trading against investors'.
Remember, warrants are simply another financial product where it is in the issuer's interest for the investors to have a profitable experience. Therefore, many warrant issuers invest considerable sums in education, marketing and websites to help investors understand the nature and risk of the products so that they can achieve their investment objectives.
Helpful tips
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It is a common misconception that issuers and market makers benefit when investors lose money and therefore are trading against the investor. Issuers would much prefer that investors make money trading warrants, so that they continue to trade warrants. This is why issuers invest so much time and money in educating investors.
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