By TK Yap, CFA, Executive Director, OCBC Securities
Trading in structured warrants has surged to a monthly turnover of about $1.5 billion from almost nothing in mid-2004 and currently accounts for nearly 8 percent of SGX turnover and over 30 percent of SGX volumes. Veteran stockbroker, TK Yap, CFA, who is also the Executive Director at OCBC Securities overseeing its Alternative Products business, offers some words of wisdom for those looking to trade in structured warrants. He shared his views with Vasu Menon, a member of the Pulses Advisory Board.

Vasu
Is trading in structured warrants dangerous for the retail investor and can people really make money from this?
Mr. Yap
To be candid, it is not easy to make money trading anything, including structured warrants. It requires serious effort to be successful and consistent, and an ability to control greed versus fear emotions. Remember that warrants are tools. Tools themselves are not dangerous. It is using tools wrongly that can hurt you. You need skills to make a tool work for you too!

Vasu
When trading in warrants, what are the basic success factors needed?
Mr Yap
I would say have basic knowledge, understand your personal psychology, and have basic trading skills.
Knowledge – Know how warrants work. For example, why warrant market makers will widen their bid-offer spreads as warrants get deep-in-the-money, which is a fact of life. Or how out-of-the-money warrants perform compared to in-the-money warrants. Or why delta is important, which explains why some warrants follow the mother share price better, and others do not. Or, why buying a warrant priced at a high implied volatility could see your warrant not performing. Most importantly, realize that the underlying stock must move – if it does not, the warrant will not either.
Personal Psychology – Understand yourself as to whether you are naturally a trader or an investor, as both can succeed through warrants, but not if you go against your natural style.
Skill – Acquire trading skills because trading requires both a balance of fundamental and technical analysis skills, the instinct to spot the next good bet, and the nose to avoid trouble if the price action does not seem right.

Vasu
Is it important to have a trading plan and targets, or is it better to let profits run?
Mr. Yap
Yes, of course. It is important to have a target in mind as part of your trading plan. In other words, have a clear idea where you want to get out if your long position goes up, and where you need to get out if your warrant goes down. Once you go long on a warrant, know your reason for going long, staying long. If that reason is no longer there, you should not still be long. Your reason for holding is the same as your reason for buying. Once you buy, your need to have two exit prices in mind. One is where you take your profit and the second is where you cut your losses. The two must be a reflection of the risk-reward ratio of your trade, which is commonly three-to-one as a rule of thumb. So, having a plan is about knowing why you entered a trade, why you are still in it and knowing why you should be out.

Vasu
What would you consider to be a “golden rule” of trading?
Mr. Yap
Make sure you do not erode your capital so much that you cannot bounce back. That means your must have stop losses. There are different versions of this story, but when a very successful investor was asked about his basic approach to making money, he said it in two words – “Don’t lose”. Once your capital is gone, you are done.

Vasu
Can technical analysis really help in trading warrants?
Mr. Yap
It can be a useful tool but you must know how to use it. Sometimes there may be a tendency for some of us to rely on too many technical indicators and get ourselves confused rather than concentrating on what fits our trading style and personality best. Sometimes we can get lost in different kinds of indicators, which may give conflicting signals, instead focusing on simple price action. Again, one cannot be right all the time, but there will be times we must surrender to the market, walk away and live to fight another day. Charts can help you do that.

Vasu
With so many warrants, how does one make the right bets?
Mr. Yap
Go back to basics. Warrants move because the underlying stocks move, which can be for fundamental, technical or fund flow reasons. So, start with picking the right stock. It is important to look at the charts just to find a stock that seems ready to move, that is being set up for a move. Then watch for the trigger signals to establish a position. At the same time, do you homework on warrants by going to the issuers’ websites that have warrant calculators so you can simulate the potential return on a warrant when the underlying stock moves. Narrow that list of warrants down, then watch both the warrants and the underlying stock for the start of a trading move. Listen to the market, because market do not care what anybody thinks. It can move against expectations. So, feel the market vibes. Serious bettors do not bet blindly. They do their background homework, then make calculated bets, and when they are off form, they know when to call it a day.

Vasu
Any final words of advice?
Mr. Yap
Remember the two words “Don’t lose”. In the May 1989 edition of the SES Journal (as it was then called) I wrote an article titled “Investing in the stock market – How to win a loser’s game." I think a lot of things I said 15 years ago still apply today. Trading in warrants is an extension of that. At my firm, we came up with eight key warrant trading rules based on what we observed in the warrants market. We have shared this with our dealers and remisiers, as well as the investing public when we go out to give investment/trading talks. They are simple rules, but they surprised some people who did not really think in these ways. Here they are:

Rule 1: Minimise overnight exposure. Especially on the volatile stocks because of the risks of gapping down on the open. As a guide, I would suggest 50 percent of the intended position, with the other 50 percent initiated and closed off during the day. Remember some stocks have ADRs that trade, so when the underlying stock opens on SGX it can gap down 20 – 30 percent and you cannot react. Or during results season, a below expectations announcement can also cause a gap down, and you can be down 20 – 30 percent at the first trade. It can give you a very helpless, sinking feeling.

Rule 2: Use an absolute dollar loss as stop loss. Not a price!!! This caps your “betting loss” or exposure and imposes the discipline of tighter stops for larger positions which is more logical – in case the trade goes against your call.

Rule 3: Implement a clear exit plan. Execute stops with discipline once decided, to minimize your loss.

Rule 4: Spread larger trades over different issuers on the same stock. This is because sometimes software and other problems or reasons can mean bigger spreads and smaller quantities from the market maker. Consequently, there is greater price impact when you square…

Rule 5: Lock in sudden profits when the stock gaps up – in order not to lose it all back. Then move on, unless you are very convinced that on the stock and want a longer term position anyway.

Rule 6: Trade warrants with under two months to expiry very carefully. If you have to trade them, then contra trade the warrants with under two months to expiry. If the intention is to hold longer than T+3, then go for warrants with over two months to expiry.

Rule 7: Do NOT HOLD on to the warrants, unless you are sure of the reasons for holding on. Remember most covered warrants are more suited for trading, not for holding.

Rule 8: Think of warrant positions in nominal terms, not absolute. Leverage works both ways so the warrant exposure plus cash should be equal to the dollar position in the underlying stock as a starting point. Work upwards from there according to your risk appetite.