Published September 29, 2008

WARRANT INSIGHTS
Possible strategy for uncertain market

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THOSE who have watched the local warrants market closely would have noticed that just like the broad underlying market, turnover has tapered off over the past few months - average daily volume is now around $55-65 million, compared to last year's $100+ million.

The reason is, ironically, the huge spike in uncertainty and volatility - although warrants and options are instruments that thrive on volatility, current conditions are simply too unpredictable. As a result, the over-the-counter (OTC) options market is often unable to properly price the securities, and this spills over to the warrant market because warrant issuers rely on OTC options to hedge themselves.

What should investors do under such conditions?

One possibility is to buy a call and put on the same stock with short maturities, not to profit from a sharp change in implied volatility but instead from a sharp change in the underlying's price.

For example, suppose that a stock trades at $10 and has a call and put, both expiring in a month, with exercise prices of $10 (ie, the two warrants are at-the-money).

Suppose that both warrants trade for the same price of 20 cents each. Assuming no transaction costs and a 1:1 conversion ratio for the sake of simplicity, buying one lot each will cost a total of $400.

Now, let's assume that the underlying rises to $11 at maturity in a month's time and the warrants are allowed to expire. The cash settlement from the call will be $1,000 while the put generates nothing. The profit, however, from the trade is $1,000-$400 or $600, which is a rate of return of 150 per cent. (Note that the same potential payoff exists if the stock falls to $9 and the cash settlement comes from the put warrant).

However, suppose that the stock only rises to $10.30 at expiry. The call's payoff of $300 will not be enough to cover the cost of the $400 trade and the investor suffers a $100 loss.

From the above, it's obvious that the strategy will only work if the stock moves beyond a certain breakeven point, ie. its fluctuations are wide enough. It is therefore best if investors study all relevant factors like the charts and near-term macro outlook and figure out for themselves the probability of the underlying's price rising or falling by the desired amount.

This column is brought to you by Merrill Lynch