Monday, 5 February 2018

HOW TO CHOOSE A CALL WARRANT ON BURSA MALAYSIA : A SYSTEMATIC APPROACH

Investment banks love to issue call warrants as much as people love to trade them. It seems like a new one comes out every week.

Let's say you're given a list of call warrants to choose from. How on Earth do you pick one out? I get asked about this often. Honestly it took me years to provide an answer other than "just buy the top volume one lah!".


I'll use Hengyuan as an example.


One dad, 18 children. All asking for your money.

Based on this, if you're stingy with your money (like me), you'd probably gravitate towards the cheaper ones at the bottom - and you'd be partly right. But there are still six that are reasonably priced between 18 sen and 32 sen. So you still need to filter your choices.


I'll explain how I approach this problem, along with a few market quirks that may help you in your trading. Note that I won't go into the technical details, but if you're interested in that, check out Macquarie's warrant website. 


You can adjust the profit target and timeline to your own preference. I'm using my own for illustrative purposes.


SETTING A TARGET

The first step is something that sounds like it came straight out of a self-help book: where do you want to be and how do you want to get there?

In other words, what are your specific targets?

Mine is : a profit of 15-30% per call warrant trade. Any less and it's not worth my time and effort. Any more and it's an added bonus. The profit target represents the leveraged characteristics of call warrants; it's why you can boost your profits with a lower amount of capital.

Using the 30% target as an example, here's a visualization of what it takes to get there:


Some general observations  :

- The higher the warrant's price, the quicker it moves relative to the mother share (Delta).
- The higher the warrant's price, the more illiquid it becomes (when close to expiration, the issuer has most likely sold off its entire inventory to retailers).
- The closer to maturity a call warrant is, the more illiquid it gets (lack of trading interest, lower market making activity by the issuer).
- If the mother share stagnates, the call warrant will steadily decline (time decay).
- If the call warrant is cheap (like, at 9 sen), don't expect it to move much even if the mother share rises 10% in one day. With a 30% profit target, your target price is at 11.5 sen.



Let's rule out CA to CG as they're nearing expiry. As at January 27, CG has 62 days left to expiry, but after discounting weekends it's much closer to 40. I never trade call warrants with 60 days or less towards expiry.


The main reasons : 


1) You're putting yourself in a corner. If the mother share doesn't move in the next two weeks (already a fifth of the call warrant's remaining tenure), you will lose money. Additionally, you will have trouble getting out if your position is large (100,000 units or more) as the call warrant will become more illiquid.

2) The liquidity factor means that your risk outweighs your reward. If Hengyuan rallies, of course temporarily there will be improved volumes in the bid-ask spread, and the call warrant's price may move faster. But if the share quickly declines, you'll have a problem with taking profits as the volumes dry up. Everybody's selling at the same time.

3) You have better warrants to trade : cheaper, newer ones. The price of CA to CG reflects previous big rallies. Your upside potential is clearly limited by now with the old issuances.


SETTING A THEME

Decide on your thematic angle and potential trading periods. There are broadly three main types:
1) Proactive : Are you building up a position to ride the momentum? (two weeks or more)
2) Proactive + Event driven : Same with 1) but you're planning a trade in anticipation of Hengyuan's next earnings disclosure, for example. (two weeks or more prior to the event)
3) Reactive, speculative : You're putting on a speculative position after noticing that Hengyuan is up 5% today. (a few days)

The theme helps with determining your timeline. Set very specific deadlines ; if you're not profitable by then, it's not the market's fault. You could've got in at a bad price or you could've missed out on the chance to take profits. It's better to feel stupid with a RM200 loss than RM2,500.


WHAT CAN YOU AFFORD?

It's just like shopping at the supermarket : there's a trade-off between a call warrant's price and how much of it you can buy. Your risk appetite and capacity to trade in size are also important. There are no right or wrong answers; some trade 100 lots, others trade 100,000 lots.


My personal preference : somewhere around 1000 lots (100,000 call warrants). Less if I don't like the mother share's volatility, more if I'm already profitable with my position and I'm keen on adding to it.


Because of this, I tend to buy call warrants that are priced between 17 sen and 30 sen. Anything higher (like, 50 sen) means that I'll only be able to buy half as many warrants with my capital. It takes longer to get to the 30% profit target and with less warrants, so my actual profits may be smaller. Of course, there are exceptions. If I find a call warrant at 32 sen and it has all the right characteristics, I'll buy that.


Anything less (10 sen) means that only a truly big move in the mother share can trigger a major move in the call warrant. Another problem : the volume can be too high (everybody wants to buy the cheapest warrant with the most volume). Any move to the upside can be slow and you'll be at the mercy of high-volume traders, syndicates, or the market makers. It's like trading SUMATEC nowadays; it takes 100 million shares traded for the stock to move up 0.5 sen, if it moves up at all.


Too much liquidity is not good : call warrants are not popularity contests.


OBSERVE THE BEASTS

Using my own preferences, so far I've narrowed it down to five call warrants: CN, CO, CO, CP, CQ, and CR. The next step is very important: monitor the call warrants for a few days. Make an assessment of the trading interest in the call warrants.



There has to be a reasonable level of liquidity and trading interest. Let's compare two types of buy-sell queues (or the bid-ask volume):

(1) Good.

(2) Bad


Liquidity is a function of two things : retail participation and market making. Market making is simply the automated buy and sell volumes provided by the issuer throughout the trading session: they need to give you some liquidity so you'd trade their call warrant. (1) shows a fairly illiquid buy-sell. It can be expected to move up quicker as there's little volume pressure in the sell queue.


On the other hand, (2) demonstrates the perils of too much liquidity. Clearing the sell queue at 0.085 requires the market to buy 50,000 lots - you're essentially at the mercy of other large-scale traders. Expect the same kind of volumes at 0.09, 0.095 and so forth : achieving your upside takes time. Due to the time-sensitive nature of call warrants, this is clearly not good.


LOOK AT THE TERMS - BUT DISREGARD SOME OF IT

This is where it gets a little complicated.

Hengyuan-CN -what?


Here's a less detailed table for comparing the five call warrants:



Data as at January 26, 2018. Hengyuan's stock price : RM13.68.

This link explains the technical terms of call warrants better than I ever could. But from a more practical standpoint, my choice of warrant largely depends on day-to-day liquidity, the bid-ask spread, and volume. 


In short term trading, the main considerations should be on the practical aspects of trading - ease of entry, assurance of liquidity, and so on. The terms are useful if you're comparing call warrants on a long term standpoint, but these call warrants will expire in just under eight months. At Hengyuan's current price, these warrants are hopelessly out-of-the-money anyway, so the information provided above is of limited value in the context of short term trading.


Here's a couple of indicators that can be useful:



Simply put, sensitivity is how much the mother share must move to get a corresponding 'tick' (0.5 sen for warrants below RM1, 1 sen for warrants above RM1) in the price of a call warrant. So in the case of CN, Hengyuan must move by 8 sen for the call warrant to move by 0.5 sen, up or down. Note that at Hengyuan's current price, an 8 sen move is only four ticks (stocks above RM10 move in increments of 2 sen).


CQ and CR's higher sensitivity is a reflection of their cheap price (16.5 sen each) and higher conversion ratios than the other three. This does not make them worse picks than the other three. CN has the lowest ratio out of the five and is also priced at 16.5 sen, but its exercise price (RM24) and effective gearing is far above the other. Again, the trade-off is there (buy cheap in return for higher risk and a ridiculous benchmark in the exercise price).


Don't view the exercise prices as a realistic target for the mother share. Think of it as a reference point for the issuer in pricing the warrants. But if your analysis suggests that Hengyuan's shares can hit RM19 in the next 7-8 months, feel free to hold a very risky, long term leveraged position (this is something I wouldn't do due to the time decay effect and external risks, particularly the volatile crude oil price situation).


The number of shares issued is the other important indicator. It's useful in determining the potential day-to-day liquidity and volume in any given call warrant. Note that a lot of these warrants were very recently issued; you need to observe the call warrant's behaviour over a period of at least a few days to determine whether it meets the liquidity and volume criteria.


PICK ONE

My personal pick out of the five (again, there is no right or wrong here)  is HENGYUAN-CO. It straddles between two extremes. The conversion ratio is not too high (18), the effective gearing is the lowest (1.8 times) and the exercise price is among the lowest of the newly issued warrants. Its sensitivity is the best (although there's little difference between CO and CN) and the number of shares issued should mean fairly reasonable liquidity in the medium term. In comparison, there's only 21 million CN warrants out there, so you might face day-to-day liquidity risks once the inventory is fully sold to the market.


THINGS TO WATCH OUT FOR

1) The call warrant might not be liquid all the time : this is the main liquidity risk that you'll face daily. During a selldown scenario (such as when Hengyuan shares drop 5%), there may not be any automated market making activities temporarily. You may also see lower automated market making activity (with 500 lots in the bid-ask instead of 1,000, for example). Another major risk is that you may see sellers entering the market at the same time to dispose of their holdings. This is why the number of shares issued is an important measure : too much volume and you'll face a flood of selling.

2) The call warrant does not reflect fair value all the time. Technically, all five warrants are considered worthless except for their inherent time value - essentially the call warrant's potential to achieve moneyness. At some points, the call warrant will accurately be a reflection of Hengyuan's current price : this means that the sensitivity will remain constant. At other times, retail trading interest can cause the call warrant's price to overshoot - good if you're already holding a position. At this point I'd usually sell my holdings, which is the moment I can no longer accurately assess the call warrant's value and price targets.

Comparing Hengyuan's % gains VS Hengyuan-CD. Note the point of divergence/overshoot in November - essentially the starting point where your gains in the warrant will greatly exceed that of the mother share, even without the leverage factor.




3) Historical volatility affects future price performance of the call warrant. This is separate from the time decay effect. Here's a simple example: Hengyuan-CO experienced extreme volatility on the first day of trading - it went from 3 sen to 29 sen in a day. From this point on it is highly likely that the 30 sen mark will be judged as the 'resistance point'. Naturally occurring profit-taking activity in the market at the 30 sen point could affect the call warrant's ability to fairly reflect the increase in Hengyuan's shares.






SUMMARY

It's OK to trade based on top volume activity. It's also OK to choose based on the moneyness, delta, implied volatility, etc. The most important thing is to enter into a trade when the call warrant is fairly valued, set a target, and exit when the target is achieved. You can chase the market, but never repeatedly. Set deadlines, or the market will force you out of your position when you're wrong. Call warrants are riskier and volatile, but you can also earn major profits from the same risk and volatility.





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