| Naga Golden Rule 2 |
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| The Selection Process |
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| Outlook for the Underlying |
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| Risk Tolerance |
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| Terms of the Warrant |
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| Comparison of Implied Volatility |
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| Comparison of Issuers |
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| Expiry |
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| Exercise Price |
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| Effective Gearing |
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| 1. |
Outlook of the Underlying
When selecting an underlying asset, you should consider the direction, extent and pace of its movement. In order to estimate the direction of the underlying asset, you can do so by analyzing the fundamental aspects, technical analysis aspects and market news of the underlying asset. |
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| 2. |
Risk Tolerance
There is a common quote, "the higher the risk, the higher the potential return". You should not pick a warrant solely because the absolute warrant price is low. More importantly, you should understand your risk tolerance when selecting a warrant to match with your risk appetite.
If you are a high-risk-tolerant trader who expects a sharp rise in the underlying asset, you could buy an OTM call warrant with higher effective gearing and shorter expiry period to optimize the warrant's return.
Be mindful that a higher potential for return could also mean a higher risk of loss.
In contrast, for a conservative investor, you may prefer an ITM warrant with a longer expiry period. |
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| 3. |
a) Warrant Expiry
Warrants have a limited lifespan. The time to expiry of a structured warrants in Malaysia range from 6 months to 5 years.
A warrant with a longer lifespan will allow you to have more time to make a gain in trading. The longer the warrant is away from the expiry date, the greater the time value and you may have a longer timeframe to realise your trading gain. A close-to-expiry warrant tends to be cheaper as it has undergone a significant loss of time value.
If you are a conservative investor, you may prefer to select a warrant with a longer expiry while a risk-taker may select a warrant with a shorter expiry. You should always pay attention to the expiry date of the warrant as the time decay rate increases as it approaches expiry.
b) Exercise Price
As explained in Naga Wisdom 4: Warrant Pricing - Intrinsic Value, only ITM warrants have intrinsic value. Hence, an ITM warrant is more expensive than an OTM warrant. If you are a conservative trader, ITM warrant may be more suitable for you. OTM warrants have a higher risk of becoming worthless at expiry, therefore it is more suitable for a risk-taking trader.
c) Effective Gearing
Effective gearing is a leverage indicator; useful for a trader to study the relationship between the warrant and the underlying asset. A conservative trader will be attracted to ITM warrant even though it comes with lower effective gearing. An OTM warrant, on the other hand, has a higher effective gearing, which carries a higher potential risk and return, hence, suitable for risk-taking traders. |
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| 4. |
Comparison of Implied Volatility
Implied volatility is the one most crucial elements in determining a warrant price. However, using only implied volatility to determine the relative value of a warrant is wrong, or at best, misguided.
Select the lowest implied volatility among similar warrants
You could compare implied volatility of a warrant with warrants of similar effective gearing, exercise price and expiry over the same underlying asset before deciding whether that warrant is expensive. Higher implied volatility means a higher warrant price. Your aim may be to choose a warrant with the lowest implied volatility among warrants with similar terms and underlying asset.
Liquidity
A liquid warrant is likely to have a higher implied volatility but it could be worthwhile to pay a little extra for you will be able to buy or sell the warrant at ease and within a tight spread. |
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| 5. |
Comparison of Issuers
In Malaysia, the structured warrant issuer either acts as the Market Maker or is allowed to appoint one Market Maker for the warrant issued. A good Market Maker will ensure sufficient liquidity in the particular warrant by continuously providing competitive buy and sell quotes, making it easier for you as investor to trade. during the trading hours. By doing so, the Market Maker also ensures price stability on the warrant price.
It is important to choose a warrant issuer that offers a good market making service
Naga Golden Advice
You should carefully consider the factors affecting the potential return of a warrant before investing in your choice of warrant. The key is to constantly review your investment objective and regularly monitor the performance of your warrant. |
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Warrants Basics
