Help with understanding warrants

Just trying to get a feel for some of this warrant stuff, and as an example, am looking at three put warrants on ZFX, as shown below:



ZFX last closed at $9.62. The above information came from the OZWarrants website.

I haven't received my books on options yet (and no, I haven't worked my way through all those formula in Cox & Rubinstein!), but have a few questions about some of the figures here. I know they've just come from the Black-Scholes formula, but I'm trying to get some feel for how they relate to the actual market situation for ZFX.

So, here are some comments based on what I understand so far, and some questions. Please correct me where I'm wrong (which will likely be nearly everywhere ).

1. All three warrants are ITM, WOR the most and WOS the least (easy bits first!).

2. WOP has a conversion factor of 3 compared to 4 for the other two. Does this matter if there's no intention of exercising the warrant? I gather though that the warrant price should be multiplied by the conversion factor to get a price that can be more directly compared to the underlying price (eg. WOP would be $1.20 per $9.62 underlying share).

3. Since WOP has a delta of -1, the effective gearing is just -9.62/1.20 = -8.02. Similarly, WOR has a per-share price of $3.08 and an effective gearing of -(9.62/3.08)*0.53 = 1.66.

So far so good, I think. Now, the trickier bits:

4. The main parameters of price, delta, time decay, and implied volatility, are all related by the Black-Scholes formula. But what logically determines the value of each parameter? They're presumably not all just plucked out of thin air to come up with some arbitrary price based on the formula. So:

4a) WOP has an IV of zero while WOR has an IV of 110.8. Since they're both based on the same underlying, and are both significantly ITM, why would their IVs be so different? WOP is about a month closer to expiry, but then WOR is deeper ITM. What is the warrant IV value telling us about the volatility of the underlying share?

4b) WOR and WOS both have the same expiry date, but WOS has a higher time decay factor, meaning it's value decreases faster with time. Is that primarily because it's much less ITM?

4c) What mainly determines the delta? WOS and WOR have the same expiry dates and very similar deltas yet one is quite a bit deeper ITM than the other. And WOP's delta is -1. Is that primarily because it's well ITM with only 45 days till expiry?

4d) Also not quite sure why OZWarrants would rate WOP low risk when it has by far the highest effective gearing.

Okay, that's enough for the moment. I can see how these figures can be used with the formula to calculate a price, or including price to come up with an IV, but I'm just trying to get an idea of what determines the value of those other parameters in the first place.

And as a practical application, if you thought ZFX was going to drop again tomorrow and wanted to use one of these put warrants to capture the move, what factors would you consider in determining which one would be the best to use?

All comments welcome

Cheers,
GP

GP I'm new to this stuff as well so curious to hear what the answer is from the experts - one comment I'd have is what is the trade date/time that those prices are based on - maybe the price on WOP is not from Friday (i.e the price is stale is the term I think they use), or is from earlier in the day.

The other big change I've found with options vs shares is liquidity and pricing. The previous day's closing price is not a very good indicator for what price you'll be able to get the option for the next day - and if there is volatility the price you get (particularly for ATM's) will depend on what the underlying is doing and will move about a lot during the day.

If the series is illiquid then the prices you get will depend on the spread the market makers give you - if there's a lot of activity it'll be easier to get a fill at the price you want.

You'll probably find that theoretical pricing tools are a better approach to getting an idea of fair value of the warrant and what sort of price you might be able to get from the market makers or other traders on the following day.

Watch out about paying too much for volatility as well (though deep ITM as I understand it you're not buying much volatility but you are long on delta which is also risky I would think with a volatile stock?). (by the way I'm using these terms but have only really started to understand them over the last week so could be making a complete goose of myself LOL).

My comments in blue FWIW

GreatPig said:

Just trying to get a feel for some of this warrant stuff, and as an example, am looking at three put warrants on ZFX, as shown below:

ZFX last closed at $9.62. The above information came from the OZWarrants website.

I haven't received my books on options yet (and no, I haven't worked my way through all those formula in Cox & Rubinstein!), but have a few questions about some of the figures here. I know they've just come from the Black-Scholes formula, but I'm trying to get some feel for how they relate to the actual market situation for ZFX.

So, here are some comments based on what I understand so far, and some questions. Please correct me where I'm wrong (which will likely be nearly everywhere ).

1. All three warrants are ITM, WOR the most and WOS the least (easy bits first!).

2. WOP has a conversion factor of 3 compared to 4 for the other two. Does this matter if there's no intention of exercising the warrant? I gather though that the warrant price should be multiplied by the conversion factor to get a price that can be more directly compared to the underlying price (eg. WOP would be $1.20 per $9.62 underlying share).

Yes, but the conversion factor also serves to to amplify the bid ask spread. So the bid/ask spread must be multiplied by the conversion factor as well to get an idea of the increased contest risk

3. Since WOP has a delta of -1, the effective gearing is just -9.62/1.20 = -8.02. Similarly, WOR has a per-share price of $3.08 and an effective gearing of -(9.62/3.08)*0.53 = 1.66.

So far so good, I think. Now, the trickier bits:

4. The main parameters of price, delta, time decay, and implied volatility, are all related by the Black-Scholes formula. But what logically determines the value of each parameter? They're presumably not all just plucked out of thin air to come up with some arbitrary price based on the formula. So:

4a) WOP has an IV of zero while WOR has an IV of 110.8. Since they're both based on the same underlying, and are both significantly ITM, why would their IVs be so different? WOP is about a month closer to expiry, but then WOR is deeper ITM. What is the warrant IV value telling us about the volatility of the underlying share?

Firstly; regarding the price quoted. This is in all likelyhood the last traded price, which may bear no resemblance to what the current price may be. That warrant may not have traded for several days. You need to see the current bid/ask to get an idea of actual current value.

The IV of zero is incorrect based on the numbers presented. For IV to be zero, there would have to be zero time value in the warrant (intrinsic value only) There appears to be time value (if the quote is to be believed) so there must be volatility. A red herring there.

4b) WOR and WOS both have the same expiry date, but WOS has a higher time decay factor, meaning it's value decreases faster with time. Is that primarily because it's much less ITM?

Yes, time decay is highest ATM and decreases the further AFM(away from the money) you get.

4c) What mainly determines the delta? WOS and WOR have the same expiry dates and very similar deltas yet one is quite a bit deeper ITM than the other. And WOP's delta is -1. Is that primarily because it's well ITM with only 45 days till expiry?

Delta is an output of the pricing model and it should be said that these are theoretical values only. When away AFM, the delta is greatly affected by time till expiry and volatility. Basically less time and or less volatility, increases gamma. Which means ITM options will get to delta 1 (-1) far quicker. So you are correct here.

4d) Also not quite sure why OZWarrants would rate WOP low risk when it has by far the highest effective gearing.

It depends how they quantify risk, without this info, it's hard to say

Okay, that's enough for the moment. I can see how these figures can be used with the formula to calculate a price, or including price to come up with an IV, but I'm just trying to get an idea of what determines the value of those other parameters in the first place.

And as a practical application, if you thought ZFX was going to drop again tomorrow and wanted to use one of these put warrants to capture the move, what factors would you consider in determining which one would be the best to use?

I would be looking to match position deltas with each warrant (i.e position delta will tell your risk as in terms of an equivalent share position), then have a look at gamma, position theta, and importantly, the contest risk (spread +commish)

Then pick the one that matches your view of the stock best... have a look at liquidity as well

All comments welcome

Cheers,
GP

Click to expand...

Thanks Wayne.

Yeah I just checked my charts and the WOP warrant last traded on 30th May, whereas the other two both traded last Friday. And I can't see the current bids & offers, as I gather the MM only displays them during trading hours.

The volumes also look pretty low, compared to what I'm used to. For example, on Friday WOS traded 24,800 warrants at 46.5 cents, which is only $11,532 for the whole day. With a conversion factor of 4, I gather that equates to 6,200 shares, which at the current price would be worth $59,644. Apparently that was four trades. Not sure if that makes this a particularly low liquidity warrant or not though.

Cheers,
GP

GP,

Re your question on an underlying falling, you have to determine what time frame you are forecasting, and what price movement you are expecting. You also need to assess what kind of risk tolerance you have (in part to determine positions size and stop loss criteria). You may find options perform better for this than warrants, but not in all cases. It is really a case by case analysis to determine the strategy that bests fits your parameters.

hisso, this might answer some of your questions in "using option greeks to trade":

Intraday:
If you’re an intraday player, you’d probably be looking for as much leverage as possible, so near the money (although some swear by OTM plays for big moves, and others swear by ITM plays so the delta is higher – both have their merits) and as tight a spread as possible (reads the more heavily traded warrants).

Theta decay becomes a non issue since you’re going to exit at the end of the day. However, this is a high risk approach, and quite stressful – factors against you are the spread, possible IV readjustment and also the exposure doing this is very high, so a major adverse movement can wipe you out, so this is classed as very aggressive in the risk category (essentially it doesn’t get much riskier than this).

Position Trading:
Again, a lot depends on your objective – how long are you going to be in the trade, and how far do you think the underling is going to move, and what risk are you prepared to undertake? If you’re going to be in a trade for a longer time, you really want to exit by 30 days till expiry since around 80% of time decay happens in the last 30 days.

Just like the situation for the intraday player selecting ITM/OTM/ATM positions depends a lot on how you think the underlying is going to move (OTM is the most aggressive, but the exposure is less, ITM is more conservative and more likely to work, but the exposure is larger – you really need to play with deltas and look at the way leveraged instruments work as the underlying moves – different players have different perspectives on this). Again, this is a leveraged trade, and is classed as high risk!


Just a few additional points:

Beware of different exercise styles – American can be exercised anytime up until or on the expiry date – European can only be exercised on the expiry date. There are subtle differences in how theses are valued (American usually dearer than European).

The theoretical values for different warrants can get complex because you are dealing in an OTC (Over the Counter) market where these instruments are not standardised (like ETO’s), and it is advisable to read through the terms and conditions of each warrants by the issuing institution, since this can have a material effect on the potential warrant value depending on possible events.

Also, be careful about conversion ratios - a price which at first looks appealing may be because you have to buy 4 warrants to equal one share (you noted this, but even experienced players have fallen for this when making fast decisions on the fly).

When you ask how to compare one warrant to another, this can get tricky. Trading warrants such as equity warrants have a different value to instalment/endowment warrants because one type yields dividends.

Also, interest rates can differ, as can the model used by different issuers for valuing a warrant. Wayne’s point about the bid/ask spread is very relevant when entering/exiting with a margin set against your position. Where it can get nasty is how the issuer deals with things like dividends, or other events which effect the underlying. Some issuers in low volume markets have been known to readjust values which can adversely affect the value of your position.

Also, because some warrants don’t trade much, looking at the “last” price can be a trap as commented on above. The price may have been days or even weeks old, so these are unreliable.

A lot to consider too is how long you intend to be holding the warrant. For short term trades with no dividend play, options may on average perform better than warrants (although this isn’t always true for a host of reasons – for instance, flex markets for options may have adverse spreads, or some options may be skewed by market activity). Shorter term approaches (depending on magnitude of the move, and the time frame) can benefit from slightly ITM or OTM positions.

As for expiry, this can get complex. Theta decay can eat into values even with a strong move, so consider looking to exit before 30 day s to expiry if you can. However, ITM positions with under 30 days till expiry can perform reasonably if your forecast is reasonably accurate, but if you get it wrong, both theta decay and adverse moves can have a significantly negative effect on your position, so caution is required here, this is a very risky use of warrants.

For longer term positions investment warrants that yield dividends and allow for reinvestment can be considered. There are still dangers because of the leveraging to adverse moves, and to theta decay. A lot depends on where you buy the strike (ITM, OTM, or ATM).

You can also use these for shorter term dividend stripping strategies, but the risk is that the underlying doesn’t recover ex – div in sufficient time. Something to note here is that these warrants change in value based on the ex div, and the price is usually readjusted by the issuer to reflect the dividend being issued, so you do need a positive move to offset this, so you’re looking for an up trending stock to do this.

Hope this is of help


Magdoran

Magdoran,

Thanks a lot for the info.

Yes it helps, and I'm sure it will help a lot more once I actually understand most of it.

Cheers,
GP