|
How to choose a warrant?
- Choose the stock first. There is no point buying a warrant just because it is cheap, unless it is for an arbitrage trade.
- Gather all the analysis relating to the warrants on that underlying asset for comparison (newspaper is a good source).
- Choose the strike: In, At or Out of the Money. Deep In-The-Money warrants can be traded at low premiums or even discounts, but offer very low gearing. Far Out-of-The-Money warrants provide good effective gearing.
- Check the warrant premium relative to its strike.
- If several warrants are available on the same underlying asset, compare their implied volatility. The idea is to buy the warrant with the lowest implied volatility as it is the cheapest but only if it satisfies the other criteria like time to maturity and gearing.
- Choose the one with the best liquidity if implied volatility are at similar levels. However, a more liquid warrant may be traded at a slightly higher implied volatility than a thinly traded warrant. In this case, it might be worthwhile to pay a few extra points for volatility as it enables investors to buy and sell effectively in good size, in tight spread situations.
Low Premium = Cheaper Warrant?
There is sometimes a misperception amongst investors that low-premium warrants are always cheaper and more preferable than those with high premiums. But this is not always correct since low premium often associates with more In-the-money and lower gearing. The premium is not the only parameter to consider for warrants valuation. Higher premium can be associated with higher gearing and does not necessarily mean that the warrant is more expensive than one with a lower premium but also a lower gearing.
Premium is used as a measure of how much the underlying has to move in the favourable direction in order for the warrant to break-even at expiry date. It does not connote any measurement of value or cheapness.
Investors should keep in mind that the major reason to buy a warrant instead of buying a stock is to have leverage. Thus a low gearing warrant is meaningless and should not be considered unless it is trading at a large discount.
Professional or more sophisticated investors very often prefer to buy at-the-money or out-of-the-money warrants, in which there is no intrinsic value. This allows them to use a smaller outlay to gain the same exposure as they would get from in-the-money warrants.
In order to efficiently choose from several listed warrants on the same underlying with similar terms, investors should compare implied volatility besides premium and gearing. If the warrants have similar term structures, the one with the lowest implied volatility offers the best value. Of course, investors should also consider the warrant's trading liquidity and the issuer's credit rating as well as their own risk appetite to determine what strike, maturity, gearing, and premium are most appropriate.
In-the-money or out-of-the-money warrants?
In-the-money warrants have a lower leverage than out-of-the-money ones and are therefore less risky. They will perform less if the underlying share price moves in the right direction but will lose less value in case of unfavourable move, as shown in table below.
The table below shows the simulated behaviour of ATM, ITM and OTM call warrants if the share price rises or fall 10%.
Underlying share price : $100
OTM call warrant strike : $120
ATM call warrant strike : $100
ITM call warrant strike : $80
| Underlying Share Price |
OTM warrant |
ATM warrant |
ITM warrant |
| +10% |
+54.9% |
+43.4%
|
+32.9%
|
| -10% |
-41.9%
|
-36.1%
|
-29.5%
|
Assuming warrants of 6 months maturity and implied volatility of 50%.
High premium of high gearing?
The higher the gearing, the higher the premium (assuming same implied volatility). Risk-averse investors will go for a low premium but will therefore have a low gearing. Risk-takers will prefer to have a high gearing but will have a high premium.
|
Warrants Handbook >
Warrants Handbook
