July 2004

I have recently noticed from the statistics of The Stock Exchange of Hong Kong Limited (SEHK), that 15.45% of the total June turnover on the Main Board was attributable to trading in derivative warrants. With 803 derivative warrants relating to 47 stocks, 3 indices and 4 currencies (what we usually call the "underlying") available for trading as of 30th June, 2004, it is little wonder that these instruments are quite popular in Hong Kong.

With this popularity in mind, I am rather interested to dig further into getting more information on why and how Hong Kong investors trade derivative warrants. Last Sunday morning, I happened to come across an investor survey report, which revealed that among those active investors interviewed, slightly over 50% have had experience in investing in derivative warrants.

While most of our investors are familiar with the usual yardsticks like gearing, expiry date and exercise price, they show less confidence in using implied volatility. I also believe some of them might have overly relied on warrant turnover as a factor for picking a derivative warrant. I would therefore like to take this opportunity to share with you some of the pitfalls in choosing a derivative warrant.

Many of you would have known that the higher the price volatility of the underlying, the higher premium the derivative warrant would fetch, theoretically. At any given point in time, different issuers might choose different estimates of implied volatility, but in the longer term, market force will make them converge. Unfortunately, for most ordinary investors, very often, changes in implied volatility can go unnoticed.

On turnover, there have been occasions where the SFC noticed that the high daily turnover of a derivative warrant was caused by active day trading activities by a limited number of investors. These investors often showed special interest in warrants issued by the same issuer. Therefore, to make a meaningful interpretation of the level of daily turnover in warrants, the turnover figures should be compared to the number of warrants outstanding at the relevant time, which I shall also talk about later. High daily turnover but with a low number of warrants outstanding casts doubt on the true popularity of the derivative warrant. That's why you should not rely on daily turnover alone as the selection benchmark.

In relation to the number of warrants outstanding in the market, we must bear in mind that, under the current regulatory structure, an issuer is not required to sell the entire quantity of a warrant approved by the SEHK at the time of the warrant's initial listing. Unlike stock options traded on the SEHK or index options traded on the Hong Kong Futures Exchange, derivative warrants cannot be created except by the specific issuer, and hence a derivative warrant can stay overpriced for longer time due to limited supply. When an overpriced warrant converges to the market norm, it is likely to underperform the others. On the other hand, whenever there is demand, it is natural for the specific issuer to sell more warrants within the limit authorized. This additional supply will dampen the rise of the warrant price. You can look up information on the amount of warrants outstanding published by each issuer on the website of Hong Kong Exchanges and Clearing Limited.

Besides, the role of liquidity providers is often misunderstood. Liquidity providers are only required to ensure some minimal liquidity in the market as and when it is needed. They are obliged to quote (two way prices) on a limited scale and such obligations cease when a warrant trades below a certain nominal price. In performing this service, a liquidity provider will often quote after considering the supply and demand situation at the time.

Although many of you have known that the value of a warrant declines as the expiry date draws closer, it is also important to note that the rate of decline increases rapidly as the warrant approaches maturity. A warrant has a fixed maturity and beyond that the warrant could be worthless. Consider choosing warrants with different strike prices and maturity dates to adjust your risk profile.

And, avoid warrants with unrealistically high gearing. High gearing usually comes from low price warrants that are short dated and deeply out-of-the-money. These warrants are likely to expire worthless, causing total loss to investors.

Finally, stay away from exotic warrants (usually signified as XC or XP by their names) if you do not understand them. Exotic warrants are far more complicated than standard warrants and cannot be priced without a detailed analysis of the terms of the warrants. Because of their special features, it is almost impossible for most retail investors without specialist knowledge to evaluate. The listing document is the only place to find authoritative information on the terms of a warrant.

Decide on your own risk appetite. Risk and reward are the "twins" of any investment. Before thinking about how much profit you can make, think about the potential loss you can afford. As in all investments, know what you are buying before you invest in the product.

1. "Number of warrants outstanding" is reported by an issuer daily to reflect the quantity of warrants sold by the issuer and are still out in the market.