How to find the right Warrant

Toss-up between risk appetite and indicator analyses

All investment decisions are centred on certain principles, such as investment type and the investor’s risk appetite, i.e. conservative/risk-averse or more aggressive/risk-tolerant. The investment objective is also important: is the investment for speculative purposes, for reducing risk exposure or hedging, or does the investor want to make specific adjustments to risk/return profiles with a combination of financial instruments?

How to find the right warrant

Compared to direct investments, warrants vary on a qualitative, as well as quantitative level. In order to make a well-balanced investment decision, investors must have access to reliable and up-to-date information and must be fully aware of the risk/return profile of these investments. Knowledge and understanding of all parameters affecting the performance of warrants is therefore essential.

The selection process can be broken down into three phases: the information phase, the decision phase and finally the control phase.

  • First of all, investors must obtain detailed information on the market environment, as well as the product features and respective underlying assets. A basic prerequisite for investing in warrants is a very clear idea as to how the price of the underlying is going to perform, as well as the period of time in which this price movement is likely to occur.
  • In the second phase, a decision should then be made on the investor’s maximum risk tolerance, the amount of capital to be invested and which warrant features would best suit the investor’s investment objectives. The quality of the information and services provided by the issuer should also be taken into account.
  • The third phase ultimately begins when the warrants are acquired and includes all measures undertaken up to the exercise or sale of the position. During this phase, the investor mainly measures the performance of the warrants, monitors their prices and controls the investment.

Whether an investor buys a call or put warrant, plus the maturity and strike price are all dependant on the investors expectation, about the direction and extent of price movements in the underlying, as well as the investment horizon. The choice of strike price is determined taking these factors into account as well as the current market price of the underlying.

Speculative investors tend to choose a short maturity, as well as a strike price that is either “at the money” or slightly “out of the money”. The more conservative investors typically opt for longer maturities and a strike price that is “in the money”.

When investing in warrants, there is little point in focusing on individual indicators. A combination of indicators will provide a more overall picture, which is vital. Investors who predict a sudden and sharp change in prices are going to opt for different warrants than investors who wish to speculate on slow but steady price movements. Something to watch out for, in any case, is that warrants have sufficient time to maturity, i.e. warrants with a delta of less than 0.15 for calls and –0.15 for puts are generally considered to be particularly risky, and investors looking to invest in these warrants should take particular care to ensure that they gather the necessary information.

Given that the smaller the delta, the greater the influence of implied volatility, investors who have a choice of two otherwise identical warrants, should consider the warrant with the lower implied volatility as it will be cheaper.

Investors should also pay careful attention to the bid-offer spread between the purchase and sale of warrants. This as the price of the warrant must rise by at least the spread amount in order to ensure a loss-free investment. Investors should however consider the exercise ratio when assessing the size of the spread as a one-cent spread for a warrant with an exercise ratio of 100:1 means a TRY 1 spread for the underlying. By contrast, a two-cent spread for a warrant with an exercise ratio of 10:1 means an underlying spread of a mere 20 cents. Investors should therefore look at the homogenised spread.

Liquidity is the key

Liquidity is an important factor to consider when buying a warrant. At any given time, one needs to be able to exit his position, either for taking profits or cutting losses. Under the current ISE Listing Rules, issuers are required to make markets for their warrants and they achieve this by continuously quoting a price at which they will sell the warrant to investors and a price at which they will buy the warrant from investors. This means that liquidity in the warrant is guaranteed.

The circumstances under which liquidity will be provided will be set out in the listing documents, but in general, the ISE requires liquidity to be provided for warrants during trading hours of the warrants sector. Liquidity will not be provided when the security underlying a warrant is suspended because the Listing Rules provide that under these circumstances trading in the warrant will also be suspended. There are also other circumstances under which quotes will not be provided by the issuer. For example, when an issuer has no warrants available for market making activities the issuer will only quote bid prices for the warrant. When the fair value of a warrant is less than TRY0.01, issuers will generally not quote bid prices for an issue.

Valuation of a Warrant at Expiry

The relevant payout formula and determination of the closing price will be set out in the issuers listing documentation. Generally, this will be based on the official ISE volume weighted average price for the second trading session of the underlying equity