Labels

Sunday, 2 December 2018

HOW-TO GUIDE : THE ONLY WAY TO TRADE INDEX CALL WARRANTS PROFITABLY


The last quarter of the year has been pretty lousy for the market, and for traders - we're sure you agree with us on this.  Some say the bear market has already begun. For us this is clear, at least for certain stocks that were market leaders as recently as two years ago. Global economic growth is losing steam - there's no better indicator of pain in the stock market than that.

 Not sure if Trump is talking about the GDP or his own brain capacity OH SNAP (Source)



See stocks like ARMADA, ASTRO, STAR, and FGV - all have been making new all time lows, and for good reason - fundamentally their business model no longer deserve premium valuations.


So much value destruction in barely a year. 


So what is there to do? We've touched on this topic before - what can you buy or trade in a bear market? Sure, you can express your bearish views by trading put warrants or sell short index futures - the KLCI certainly seems to be heading south. 


You can certainly make money by building up a large put warrant position or by short selling index futures, but it's equally likely that you will get hit by volatility. You shorted when global markets dropped 10%? Congratulations on losing most of your money as they rebounded very, very strongly.


30 November 2018 : the face you make when you recover 1% of your 30% loss. Source


Without over complicating things, these are the usual strategies employed during a bear market:


1) Buy index linked put warrants (you profit as the market falls) - Momentum trade


2) Sell short index futures contracts (you profit as the market falls) - Momentum trade


3) Buy index linked call warrants (you profit as the market rises) in the hope of being at the bottom of a market recovery - Mean reversion trade 


Our thoughts on these? Based on our collective experiences lasting five years and three serious bear market phases (where the KLCI dropped at least 100 points or more), we think the chances of profiting from these approaches are minimal. In fact, it is highly likely that you will lose money, and a lot of it. 


The issue with momentum is that people tend to assume that index linked warrants perfectly follow the direction of the market; but this is not the case at all. Aside from the usual time decay factor (there is less correlation between an index warrant and the market as the warrant approaches expiry), the market volatility will also throw such expectations further off course.


If you felt nauseous after reading that dense sentence, here's a simple comparison of gains/losses between the underlying (the Hang Seng Index) and the linked warrants - one call and one put.





 30 Oct, 2018
30 Nov, 2018
 Price Change (%)
 Price of HSI
 24,585
 26,506
 7.8
 Price of HSI-H40
 0.83
0.33
 -60
 Price of HSI-C3W
0.225
0.385
 71



If on 30 October you had bet on the market recovery (buy HSI-C3W), you'd have made a lot of money. But there was no credible justification for you to do such a trade. It is highly probable that yours was just a lucky guess.


If on 30 October you had bet on the market continuing to fall (buy HSI-H4O), you'd have lost 60% of your capital. There was every reason (and many credible justifications) to bet on the market falling further, but the market can be wrong for a lot longer that you can remain solvent.
 

We are students of fundamental analysis, and we agree that the market, be it S&P 500, KLCI, or Hang Seng, have a lot of room to fall further in the coming months/years. But you can be right about an angle but wrong about the trade.


The idea is sound but there was no good tool to express that idea (or you're not using the tool properly), so you end up buying put warrants that move like the heartbeat of someone having a cardiac arrest.


Our advice : DON'T BUY INDEX LINKED WARRANTS.



Unless....


There's actually a way to trade these fickle call warrants profitably. But there's a catch: you will have to literally be a contrarian. All the time. But is there a fair likelihood of profitability? Absolutely.


We have looked into our trading records for index linked call warrants, spanning about 45 separate trades in four years, and found that only one method is effective enough to not only make us meaningful profits, but also insulate us from losing massive amounts of money. (Editor's Note : On a long enough timeline, and when your luck runs out, there is a very high likelihood that you WILL lose money from employing strategies 1,2 or 3 as described above).


To make money, you have to show up when the market is in a state of absolute panic. It's an extension of our 'peak fear' philosophy, as you can read about in this post.


We only trade index linked warrants when the market gaps down. Here's a visual example of that phenomenon with a recent daily chart movement in the HSI:


Notice the two long green candles? The bottom is the opening price relative to the previous day's close (the gap down). They represent a decline of at least 1% immediately when the market opens


If you had bought call warrants when the market immediately opens at these gap downs, you would have made some serious profits not only within a day, but also in subsequent days. And it's not down to luck.


We strongly believe that prices are the ultimate manifestation of investors' current fears and hopes. Such sentiments determine the movement of prices, and when the sentiment peaks, you have a 'gap' situation.


When the index warrant gaps down, investors are fully pricing in those fears. There is massive selling activity driven by panic, and this may go overboard. As in a typical contrarian trade, we go in when we believe that an artificial mispricing has happened, as we would when a stock goes to limit down levels (Editor's Note : only in specific cases - not all limit down stocks present a good trading opportunity, obviously).


Or, to put it simply : investors' price in those fears by selling at price points that are excessive. We buy into those fears/excessive selling because the short term profit opportunity is appealing. Peak fear is when everything has been fully priced in; from there it can only go up, at least in the short term.


THE TRADE


Here's a real life example of us having this strategy put in practice. This is a trade on HSI-C3W on 21 November 2018.



So we look at several things before committing to a trade. Obviously the risk is that not only is the fall significant, but that it will fall further. We prefer exceptionally large declines to provide us with a bit of a margin of safety.


Looking at the situation from several angles, here was the score on the morning of 21 November.


1) HSI (the index) opened down 2.9%, an monstrous decline triggered by the previous night's tech-driven rout in the US markets.


From this we already know that while Hong Kong takes its cue from the US markets, the decline is more a reaction towards price movements rather than anything with fundamental justification. There are some huge tech players listed in Hong Kong, primarily Apple parts suppliers and behemoths like Tencent - a company so big relative to the Hang Seng's components that its stock practically moves the index around - but we checked; the price reaction is sentiment based.


2) HSI-C3W opened down almost 30%, obviously a huge decline in itself. It's an immediate reaction to the HSI's opening, as well as the HSI's futures prices.


We have a separate rule on trading index warrants : we don't trade them unless they have declined at least 20% on an intraday basis. We never buy at strength as we've stopped using any momentum strategies; we've found that they don't work.


WHAT WE DID


In the first half hour of trading on 21 November, we bought into HSI-C3W with a substantial position (100,000 warrants) at 27.5 sen. Note that the Hong Kong markets open at 9:30AM, so there's a 30 minute window where you won't find much liquidity; the panic selling usually occurs around this time.


Given the large losses in the US markets, we had an idea of how the HSI would open - we expected a decline of around 1.5-2% in the index, based on previous observation on how it correlates with the S&P500.


We thought there was a minimal possibility that the HSI would fall by 4% or even 5% - this has only happened once this year, and twice in the past three years. But just in case, we even set a time limit : if the HSI falls to 4% by 10AM, we would immediately cut our losses and exit.


Our trading parameters were somewhat simple. We set our stop loss thresholds on a case-by-case basis, but our risk-reward ratio tends to be at least 2:1 (we're willing to exit with a 1 sen per share loss for the opportunity to gain 2 sen per share or more).


For HSI-C3W, we were willing to cap our losses by exiting at 26 sen. Our profit target? 30.5 sen. Aside from meeting the 2:1 profit criteria, we also have our usual 10% capital gains target, as we do in every trade. If this trade doesn't bring our expected outcome (10% in profits or more) by 12:30PM, we are out of the trade. (Editor's Note: we are insulated from further losses by the loss thresholds and time limit)


THE OUTCOME


On 21 November, not only did the HSI recovered ALL its losses (from -2.9% to zero), it closed the day with a 0.5% gain. Our expectation was not just met, it was exceeded. We met our targets and were happy to exit.





RM4,000 in 5 hours? We can't complain. But HSI-C3W actually closed the day at 33 sen. The trade worked because we put ourselves in a situation where not only can losses be managed properly, the downside risk was limited - simply because the downside has been priced in.


And best of all, it doesn't matter if what you're trading is linked to the HSI. Can you do the same with KLCI warrants? Yes, and we have already proved it.



Popular Posts