BT: Understanding warrants on the Straits Times Index (12 Mar 2007)

Understanding warrants on the Straits Times Index

By R SIVANITHY

IF YOU'RE bullish on the local market and keen to profit from any extended recovery from the recent blowout, what are some of your options?

Medium-to-long-term players would surely look at the dividend yield stocks or 'defensive plays' which brokers have been recommending and which been featured prominently in newspapers. For more passive investors, buying and holding the Straits Times Index exchange traded fund is always a reasonable possibility.

For short-term punters, however, the options are nearly limitless. They could try their luck at any one of the dozens of penny favourites, or they could trade the more volatile blue chips such as SingTel, CapitaLand, SGX or NOL.

But if you are keen on profiting from a bounce in the ST Index, you could look at the various call warrants on the ST Index, all of which are issued by SG Securities and details are available at its website www.warrants.com

Visit this site or the Singapore Exchange's website and you'll see a total of nine structured warrants on the index - four puts and five calls. The puts are useful for those who think the index will fall in the next few weeks but for easy explanation and economy of space, we'll stick to the calls for now.

The call with the most time left is 'STI3450SGAeCW070529'. This appears confusing at first glance, but it's actually quite simple. 'STI' means the underlying asset is the ST Index. '3450' means the exercise, strike or conversion price is $3,450. 'SGAe' means SG is the issuer, 'CW' means it is a call warrant and the '070529' is the expiry date, which is read from left to right as 2007, May 29.

Note that the last trading day given on SG's website is actually May 23, and not May 29. Note also that like most of SG's warrants, 300 warrants are needed for conversion into one index value - this data appears under the heading 'entitlement ratio'.

This warrant is best suited for those who believe the index will rise above, or at least close to, 3,450 before May 23. Someone who buys the warrant at 15.5 cents now and holds it until expiry without doing anything will only break even if the index rises at least to 3,496 (3450 + (300 x 0.155)) at expiry. This is the figure which appears under 'breakeven price' on the website. Stated differently, in order for holders to receive at least 15.5 cents from SG after expiry, the index needs to be at least at 3,496.

The STI closed at 3,143.71 on Friday. So for it to reach the exercise price of 3,450, it needs to rise about 306 points or 9.743 per cent in the intervening period. As a result, the warrant is said to be 9.743 per cent 'out-of-the-money' - and this is the figure which appears under the heading 'Moneyness: 9.743% OTM'.

Because this instrument is quite far out-of-the-money, it is intrinsically worthless (why pay 3,450 for something worth only 3,143?). However, because it was only just issued and has slightly more than two months left before expiry, there is still enough time for the index to perform and for holders to make money. So the market price of 15.5 cents is entirely a time premium.

As such, interested parties should note that time decay can be expected to be a big factor in a few weeks' time, possibly as soon as three to four weeks. So if you believe the current bounce momentum will fizzle out shortly and that the index won't come near 3,450 any time soon, you might want to look at a call that's closer to the present index level.

There are two that qualify, with strikes of 3,150 or 3,300 which appear interesting and certainly worthy of consideration. The downside, however, is that time may soon be a factor for both since expiry is April 27 and the last trading day is April 23.

Finally, SG's site also provides each warrant's delta (the movement in the warrant for a unit move in the underlying), theta (rate of time decay) and vega (sensitivity to changes in volatility). These are tools for those advanced players who adopt more sophisticated trading strategies, but are nonetheless still useful for any other interested participants since they contribute to a whole picture of how the warrant might behave in the near term.

The same analysis applies to any other warrant chosen - those not keen on playing the movements in the ST Index, for example, can consider calls or puts on the Singapore Exchange instead of a play on the Singapore market.

Whatever the case, the most important considerations are these: have a view on where the market is heading, have a thorough understanding of how warrants work and do not overextend by putting too much capital into warrants.

Copyright © 2005 Singapore Press Holdings Ltd. All rights reserved.