OREANDA-NEWS. September 03, 2015. Index Put Warrants provide hedging choices. Investors can use the different strike prices and expiry dates to tailor their hedge according to their expectations of future market direction. An investor who is very bearish on the relevant index or single stocks might select strike prices well below current levels, whereas an investor who is not so bearish might select a strike price not too far away from current levels.

In terms of timing, index Put Warrants with the same strike price that expire sooner will be less expensive than those that expire later. Again, expectations and convictions of the investor will decide on which expiry date of Put Warrant he would choose.

In the case of Call Warrants, portfolio equalization strategies can be followed with variability in strike price and time to expiry allowing for similar flexibility for investors with a bullish outlook.

Examples of Intraday Warrant Moves

To show how strike price and time variables can work, consider a snapshot of these HSI warrant prices taken early in yesterday’s session, while the Hang Seng Index was trading between 21,500 and 21,600, after ending the previous day at 21,670:

  • HSI 22,200 Call Warrant with 29 Sep 15 expiry. The Warrant price was 11.2 cents, down 7.4% from the previous day close.
  • HSI 20,800 Put Warrant with 29 Sep 15 expiry. The Warrant price was 14.9 cents, up 2.1% from yesterday’s close.  
  • HSI 23,800 Call Warrant with 29 Oct 15 expiry. The Warrant price was 6.0 cents, down 9.0% from the previous day close.
  • HSI 22,800 Call Warrant with 29 Oct 15 expiry. The Warrant price was 13.7 cents, down 4.9% from the previous day close.

With the HSI starting the session with a softer tone, the 20,800 Put Warrant increased in value whilst the three Call Warrants declined in value. Hence when the underlying index declines, prices of Index Put Warrant Values not near expiry should gain in value, while Index Call Warrant Values not near expiry, should decline in value.

The moves of the Call Warrants also show how strike price and time can determine the value of a Call Warrant.

In line with the moves early yesterday, the further above the Call Warrant strike price (with the same expiry), relative to the underlying index level, the greater the decline in the Warrant value.  This is because the probability of the index moving to the higher strike levels of the Call Warrants was reduced as the underlying index moved further away from the strike price – hence with both these Warrants maintaining the same expiry date, the HSI 23,800 Call Warrant declined more in value than the HSI 22,800 Call Warrant.

Thirdly, the impact of a decline in the underlying index on the Call Warrant value is amplified with less time on the clock. Although the HSI 22,200 Call Warrant with 29 Sep 15 expiry was closer to the underlying index than the HSI 22,800 Call Warrant with 29 Oct 15 expiry, the latter saw less decline in its value. This was because was because the October expiry had more time to run, and hence more potential for the strike price to be achieved in the Warrant lifetime.

Strike, Time & Volatility

These two variables – strike price and expiry largely determine the price of the Warrant. Implied volatility in the underlying index also has a significant role in determining the price of the Warrant. As noted yesterday by Macquarie Singapore Warrants (click here) -  implied volatility is the level of volatility ‘implied’ by the current market price of a particular security. This means it is incorporated into the pricing formula for the Warrant. The higher the volatility, the higher the probability that the Warrant will end in the money, and hence the higher the price of the Warrant.

Hence if the underlying HSI was to see a significant jump in non-directional volatility, all four Warrant examples above would expect to see an increase in price , as more volatility means more potential for a strike price to be reached. Implied volatility of a Warrant may and does change over time. Implied volatility increases when the market expects wider price movements from the underlying asset in the future. The reverse can also happen if the market expects the underlying asset to be more stable in the future with less volatile fluctuation.

The aforementioned examples represented some of the most active structured Warrants listed on SGX during August. The table below details the most active 20 Warrants for the month by turnover.

As an example of the returns of the Warrants, consider that  between 4 August and 31 August, the Hang Seng index declined 11.2%, while the HSI 23,800 Call Warrant listed on 19 Aug with a 29 October expiry declined 53% and the HSI 23800 Put Warrants gained 134%.

Warrant Name Traded Value in August
HSI 23800 MB ECW151029 \\$           23,438,732
HSI 25200 MB ECW150929 \\$           19,577,188
HSI 22200 MB ECW150929 \\$           16,692,234
HSI 23800 MB EPW150929 \\$           16,013,447
HSI 20800 MB EPW150929 \\$           15,467,363
HSI 22800 MB ECW151029 \\$           14,508,370
HSI 24000 MB EPW150828 \\$           13,864,809
HSI 22800 MB EPW150929 \\$           13,113,616
HSI 24400 MB ECW150828 \\$           10,900,138
DBS MB ECW160111 \\$              8,640,494
UOB MB ECW160111 \\$              8,268,212
KEPCORP MB ECW160201 \\$              8,135,947
HSI 20600 MB EPW151029 \\$              6,924,788
HSI 23000 MB EPW150828 \\$              6,770,854
DBS MB ECW160104 \\$              5,982,535
FTSECHINAA50 10500 MBECW151127 \\$              5,149,994
OCBC BK MB ECW151201 \\$              4,921,916
KEPCORP MB EPW160201 \\$              4,303,778
HSI 22600 MB EPW151029 \\$              4,273,215
DBS MB ECW151201 \\$              3,967,965

Source: SGX

Implied Volatility of HSI Warrants

From an investor perspective, it is important to know how implied volatilities are determined and why they change.  When issuers sell Warrants to investors, they look to hedge their risks.  Market-makers use different products such as Over-The-Counter (“OTC”) options, Exchange Traded Options (“ETO”) and other structured products, and/or the underlying asset to hedge their risks from selling these warrants. When there is an adjustment to the OTC or ETO implied volatility, these market-makers often tend to adjust the implied volatility of their Warrants.

A good example is the HSI warrants listed on the SGX, this is the most popular underlying in the Singapore Warrant market. Hong Kong has a very liquid ETO market for the HSI and therefore, any changes in the implied volatilities in the Hong Kong ETO market for the HSI can have a big impact on prices for the Singapore listed HSI Warrants.

Generally, implied volatility of listed Warrants should trade in line with the corresponding listed or OTC options in the marketplace. Otherwise, arbitrage opportunities may arise. Listed Warrants are usually trading a few volatility points higher than corresponding OTC options because of all the inclusive exchange listing fees and legal costs.

Although OTC implied volatilities are not easily available to retail investors, one could take the underlying share’s historical volatility data as a reference point for the change in implied volatility. Investors should also pay attention to warrants with high open interest. Open interest is the total number of warrants sold in the market. The price of such warrants is often being pushed higher than the theoretical value, hence contributing to the increase in implied volatility.

Implied volatility also reflects the market supply and demand conditions of the warrant. If the demand for a particular warrant increases dramatically, the warrant price may be pushed up by the strong demand, hence the implied volatility increases. On the other hand, if warrant holders are dumping a particular warrant at the same time, the selling pressure will drive the warrant price down, hence contributing to the decrease in implied volatility.