The Wonderful World of Warrants
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Key Takeaways (use these links to jump between sections!)
- Warrants grant you the right to receive a stock of a company at a certain price (Exercise Price) within a set period of time.
- There are two kinds of Warrants, Company and Structured. Here we’re talking about Structured which grants you exposure (and more importantly leverage!) to an underlying share.
- When exercised, a Structured Warrant will grant you the cash difference between the Market Price and the Warrant’s Exercise Price.
- Structured Warrants come in two flavors, Call (the right to buy) and Put (the right to sell). Calls go up in price when the underlying goes up in price and Puts go up in price when the underlying goes down in price.
- While exercising your Warrant sounds great, the true value of Warrants comes from trading Warrants.
- As a result of Effective Gearing (EG), Warrant prices move in bigger strides relative to the underlying share price. If your Warrant has an EG of 5% it means that when your underlying stock price changes by 1% your Warrant price changes by 5%. This goes both ways, positive and negative changes.
- Traders can use this to earn higher returns with less starting funds
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Learn about Warrant trading strategies!
"Before you invest in Warrants or anything at all, invest in time to understand it"
- Isabelle Zhen (Kenanga Investment Bank, NagaWarrants Issuer)
The Right. Not The Obligation
A Warrant in trading refers to the right to receive the stock of a company at a certain price within a set period of time. Once the period is up, you will have the option, but not the obligation, to "exercise the warrant" by converting them into either mother shares (Company Warrants) or cash (Structured Warrants). If you’re confused by this, simply think of a warrant as a document that grants you the right, but not the obligation, to receive something; like how movie ticket grants you the right to see a film at a certain time.
Now, before we get into the bulk of this article, we must first clarify the difference between Company and Structured Warrants.
- Company Warrants are listed on the FBM KLCI and typically end with WA, WB, WC, etc. If exercised, these warrants grant you mother shares. For example, SAPRNG-WA (5218WA) is the "child" of SAPRNG (5218) and will grant you shares of SAPRNG once exercised.
- Structured Warrants are usually issued by investment banks, like Kenanga, and typically labelled with CA or CB for Call warrants and HA or HB for Put warrants. In Malaysia if exercised, these grant you cash difference between the Market Price of your underlying (mother) share and your Exercise price (don’t worry, we’ll explain this later).
For this article we’ll focus on Structured Warrants!
Call & Put
As we glossed over previously, there are two types of Structured Warrrants, Call and Put.
A Call Warrant grants you the right to buy. Confused? Consider this; you "reserve" 1 Musang King at the price of RM19.50 because you think that the price will increase to RM40 soon (perhaps you think there’ll be a shortage of durians or a surge in demand from durian-lovers from China).
Think of the RM19.50 Musang King (MK) as the underlying stock price and the RM1.50 you paid the farmer as the warrant price. Now, you believe that the MK price will increase to RM40 based on your technical analysis of durian farming behavior. So, in this scenario you could exercise your Warrant at RM19.50 (the exercise price) and sell at the market price of RM40 for a profit!
Structured Call Warrants work in the same way. If you predict a Warrant's mother share price movement correctly, the Warrant will grant you the right to buy a share at the exercise price and then you can sell at the market price for a profit. In Malaysia, you don’t actually do this process, the investment bank will simply pay you the difference automatically.
You might ask, what’s the point of buying a Call Warrant when I could just buy the underlying share at RM19.50 in the first place? Good question! Remember that piece of paper we talked about? You can actually trade that. The value of your Call Warrant should also increase because the right to buy a durian for RM19.50 when the market price is RM40 is a valuable idea. The price of the Warrant is based on the future expected price of the underlying.
This is where the main appeal is; investors can make a large return with minimal funds. Additionally, the Warrant price will change in larger strides relative to the underlying share price so you would be making a higher return than if you simply bought the underlying share. This called Effective Gearing. The durian piece of paper for example, may increase in value to RM2.60 from the original RM1.50 you paid. Many traders make use of this to increase the flexibility of their entire portfolio and enhance their returns! You don’t need to hold a warrant until expiry to reap its benefits.
Return on Investment (ROI):
MK: (RM40 – RM19.50) / 19.50 = 20.5 %
MK-C88 (the piece of paper): (RM2.60 – RM1.50) / 1.50 = 73.4%
Where a Call Warrant grants the holder the right to buy a security (like we talked about before, with the durian), a Put Warrant gives the holder the right to sell a security.
So, if you feel that the price of a stock might fall, you can buy a Put Warrant. Your "profit" then becomes the difference between the low market price and your higher pre-determined Warrant price.
Going back to the durian analogy. From the perspective of a durian orchard owner, you hear a mass producer will flood the market next season, driving the price of fresh durians down to RM20, crippling your business. As a precaution, you offer your durian enthusiast friends, RM2.50 for the right to sell 1 Musang King at RM50 per durian when the season starts. You've now paid for the right to sell durians at a future date at a set price. If that flood does come, you have the "insurance" of being able to exercise your agreement and sell durians at RM50 regardless of the market price, while secretly also buying those durians at RM20 for a profit.
But like the Call Warrant, the true value is in trading the Put Warrant to take advantage of the Effective Gearing, not in exercising it. Your RM2.50 could be worth a whole lot more if the price of durians continued to decline.
Where the value of a Call Warrant increases when the underlying share price increases, the value of a Put Warrant increases when the underlying share price decreases. This is because the value of your Put Warrant increases as the difference between your exercise sale price and the market price increases.
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Let's Talk Strategy
We suggest remembering these key "ingredients" in picking and trading the right warrants.
- Choose a good
orchardunderlying share – You want to pick a share that you think has the potential to increase in value. Have a look at our short and sweet Investment Ideas and Reports for inspiration! After all, you can't expect Musang King quality if you're buying from an orchard that grows D24.
- Use the MESTI Strategy to choose a great corresponding warrant.
- Matrix – Use a Live Matrix (like the one on NagaWarrants) to keep track of your entry and exit price goals.
- Effective Gearing - A higher Effective Gearing (EG) can lead to higher profit but also higher losses. An EG of 5% means that when the mother share changes by 1%, your Warrant price will change by 5%, both positive and negative. The change will correspond to the share price change if you bought a call warrant, opposite if you bought a put warrant.
- Sensitivity – Make sure to check a Warrant’s Tick Sensitivity and apply The Last Defense Strategy (more details below). Find your sweet spot between high Effective Gearing & few tick Sensitivity.
- Time – Try avoid holding the Structured Warrant in the final 1 month before expiry. While exercising Warrants sounds good in theory, always remember that the true value lies in trading Warrants.
- Issuer – Choose an issuer with a reputation of being transparent, reliable, responsible, and generally helpful. Don’t be afraid to ask your issuer questions! Buying from a reputable and knowledgeable orchard will decrease the chance of bad durians.
- Find that sweet spot! Try to balance the Effective Gearing with the Tick Sensitivity – Sometimes buying a warrant with a high EG isn’t an optimal choice because the Tick Sensitivity may be low. Try to select a Warrant with a promising EG and a reasonable Tick Sensitivity.
- As with all securities trading, you have to keep in mind some key risks when investing.
- Limited Lifespan – Warrants aren’t like stocks in the sense that they expire, so make sure to keep an eye on the maturity date & the last trading date (2 days before the actual maturity date).
- Leverage Risk (Effective Gearing) – As stated earlier a higher EG can lead to higher profit but also higher losses. While the Warrant value may exponentially increase with changes in the share price, it can also just as easily exponentially decrease.
- Liquidity Risk – Make sure you choose a reliable Issuer who offers ample liquidity on both sides of Bid/Ask for you to exit your trade at a fair price.
The Last Defense Strategy
Now for something a little more advanced. The Last Defense Strategy suggests counting how many "ticks" (aka sensitivity) it will take for a Warrant to change price. You can count the Ticks using a Live Matrix! Then either buy/sell your warrant just before it changes price (as shown in the picture). A “tick” refers to a single movement in the underlying share’s price.
Happy Trading!
