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Why Invest in Warrants:
We should only buy a product if it can serve some useful purpose. Likewise for warrants, there are specific scenarios where an investment will be suitable. The two usual scenarios either require a short-term forecast, or a need to protect an existing investment.
Reliable Short-Term Forecast Available
The key is to have a good forecast of the short-term direction of the underlying asset before investing in any warrants.
Since warrants expire quite quickly, they are good investments only if we are fairly certain of the short-term performance of a stock index or listed company in Singapore. For example, if we expect the STI index to drop by 10% over the next 3 months, we can buy a STI put warrant to profit from this forecast. This is because the prices of put warrants usually increase if their underlying assets’ price decreases. In addition, we already know that the prices of warrants will usually change much more than the underlying asset. Therefore, a 10% drop in the STI may increase the price of a STI put warrant by more than 10%, let’s say 40%!
However, if we feel that the price of the underlying asset will increase over the short-term, we should consider buying a call warrant instead. Any price increase in the underlying asset will usually result in a larger increase in the price of a call warrant too.
In both cases, the key is to have a good forecast of the short-term direction of the underlying asset before investing in any warrants.
Protecting an Existing Investment
The other reason for buying warrants is to protect an existing investment. This is usually done by buying put warrants only. Let’s go through a quick example using DBS shares again. If we have an existing investment in DBS shares and is worried that the share price of DBS may drop over the next 3 months, we can buy put warrants to protect our investment in DBS. If the price we paid for these DBS shares was $10 per share, and we do not want to lose more than $1 per share, what can we do?
This concept is very similar to buying insurance: pay an “insurance fee” to get protection from a drop in the … share price.
Simple, just buy sufficient DBS put warrants at an exercise price of $9. If DBS shares really do drop below $9, the gain from the warrants will help to offset the loss in our existing investment in DBS shares. This concept is very similar to buying insurance: pay an “insurance fee” to get protection from a drop in the DBS share price. The price you paid for the warrants is the “insurance fee” and represents the cost of this protection. This cost is not high too, as you’ll recall that warrants are usually much cheaper to buy than the underlying. What’s more, we can still profit from any increase in our DBS shares with this arrangement. So, if DBS price falls, we are protected. If DBS price increases, we still profit. Not too bad!
Less valid reason
Even though warrants are cheaper to buy and therefore, allow you to spread out your spare cash by buying many more warrants on different companies or stock indices, do not overstretch yourself. The typical portfolio of an investor should not contain a majority of warrants, because investing by its very nature is a long-term process. If you are investing only in short-term products, you are exposing yourself to significant risks. Therefore, freeing up spare cash by converting all existing stock investments to warrants is usually not a good idea.
What moves Warrant Prices:
There are all together 6 factors that determine the prices of warrants: Underlying Asset Price, Implied Volatility, Time to Expiry, Exercise Price …
Every warrant investor must know the factors that determine warrant prices. Otherwise, we may be surprised why the price of a warrant is not moving in a direction we have expected. There are all together 6 factors that determine the prices of warrants: Underlying Asset Price, Implied Volatility, Time to Expiry, Exercise Price, Interest Rates and Dividends.
To determine the actual price of a warrant at any time, financial models are used by each third-party bank to calculate the buy/sell prices quoted on SGX using all 6 factors. However, the first 4 factors are the major drivers of a warrant’s price. In addition, the supply and demand for warrants can also affect prices. Because so many factors help to determine warrant prices, we must minimally look at the 4 major factors before understanding how prices will move. Fortunately, there is no need to calculate any numbers at all as these information are generally made available by warrant issuers.
Let’s now focus on the 4 major factors. Bear in mind the use of “good” and “bad” in the following explanations. “Good” means the warrant price should increase. “Bad” means the warrant price should decrease.
Underlying Asset Price
An increase in the underlying asset price is good for a call warrant but bad for a put warrant.
Previous examples in this series have already covered this factor. We should now know that an increase in the underlying asset price is good for a call warrant but bad for a put warrant.
Let’s look at a quick example for a DBS put warrant with an exercise price of $15. As the underlying DBS share price increases, it becomes less and less likely that we can exercise the put warrant to sell DBS. Recall that the DBS share price must fall to $15 or below before we can exercise a put warrant. Let’s say the current DBS shares have increased steadily from $20 to $25. If this happens, our DBS put warrant’s price will most likely decrease considerably.
Since the underlying asset price is a major factor that determines the movement of a warrant’s price, we must monitor it regularly for any warrants we invest in.
Implied Volatility
A higher volatility in the underlying asset is good for both call and put warrants.
Volatility refers to how stable are the prices of an asset. For example, a very volatile share price may jump wildly from $1 to $5 and back to $3 within a short period. The third-party banks that issue warrants calculate a special form of volatility that is referred to as Implied Volatility. The details of this calculation is not important.
What investors do need to know is this: a higher volatility in the underlying asset is good for both call and put warrants. This is because there is a higher likelihood that the underlying asset price will move in our favour. On the other hand, a lower volatility has the opposite effect and pulls down the price of a warrant.
In addition, the volatility of any underlying asset’s price is not constant, and can change quickly. Therefore, it is again important to monitor volatility changes to determine its influence on the price of a warrant.
Time to Expiry
The price of a warrant can drop quite quickly as its expiry date near.
As the time-to-expiry decreases, this is bad for any warrants generally. The reasoning is simple. As the expiry date approaches, there is less time for the underlying asset’s price to move in our favour. The price of a warrant can drop quite quickly as its expiry date nears. For this reason, many investors do not bother to buy warrants that will expire within 2 weeks. This is especially the case for warrants where the underlying asset price is still far away from the required exercise price. With such a short time-to-expiry, there is a much higher likelihood of losing the money spent in buying these expiring warrants.
Exercise Price
High exercise prices are always bad for call warrants but good for put warrants.
The exercise price is pre-determined for each warrant and we cannot change it, but we should know how it affects warrant prices. High exercise prices are always bad for call warrants but very good for put warrants.
For example, just imagine a DBS call warrant that has an exercise price of $100. It’s almost impossible for DBS’s share price to increase to $100 within a few months, hence, this call warrant price will be very low and is unlikely to move higher.
4 Factors All Together
The 4 factors above should be used collectively by an investor to understand why a warrant’s price is increasing or decreasing. Forecasts of the first 2 factors will also allow investors to estimate how the price of a warrant will move in the future.
In the final part of this series on SGX structured warrants, we’ll cover the remaining concerns of every investor: the key terms that investors will come across, how to actually invest in warrants, and the specific risks of these investments.
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