Risky Business

Back to Contents of Issue: September 2000

WANT TO BUY A few shares of Yahoo Japan or Rakuten Ichiba but don't have the required amount of yen lying around? Want to buy a high-flying Japanese Net stock but want to be sure of limiting any losses? Want the chance to get VC-like returns from post-IPO stocks? All are possible through the emerging market of Japanese covered warrants.

Options and warrants are powerful and versatile investment tools, provided you know what you are doing and do your homework. There seems to be a widespread lack of understanding of warrants, and about the options markets in general. This is perhaps partly due to lack of media coverage, their complexity, esoteric market terms, and the perception that options are highly speculative instruments.

First some definitions. An option or a warrant in its most basic form is a right. In the investment markets, this is the right to buy or sell a certain security at a certain price at a certain time. They can be issued on individual stocks, a basket of stocks, a stock index like the Nikkei or Topix, and also on currencies, bonds, and commodities. Call warrants confer the right to buy, put warrants the right to sell.

Normally, warrants and convertible bonds are issued by the companies themselves as part of their capital-raising exercise. In the '80s, Japanese equity warrants were the hottest investment around. In contrast, covered warrants are issued by a party (usually an investment bank) other than the issuer of the underlying stock and have nothing to do with the capital-raising efforts of the company itself. Covered warrants are securitized options that give investors the right to buy or sell stock at designated prices during a predetermined period. For example, an investor who buys a covered call warrant will profit from the difference if the stock price is above the strike price at maturity. But principal will be lost if the market gauge is below the strike price at that point.

Covered warrants have in recent months begun to be offered on Japanese stocks due to investor demand, deregulation, and as a response to some of the unique characteristics of the Japanese markets. They offer the ability to synthetically control larger amounts of stock, limit possible loss to the upfront premium paid, and offer the potential for triple or quadruple digit percentage gains.

Covered warrants let investors obtain a highly leveraged position on a stock. For every warrant there is an expiration date, a strike price, and of course the right to buy (call) or the right to sell (put). The easiest way to understand them and the power of gearing is by way of an example:

Let's take a stock trading at ¥2 million that you think may rise to ¥3 million in the next few months. The six-month ¥2 million call warrant costs ¥500,000; the six-month ¥3 million call warrant costs ¥100,000.

Three months later, your prediction is proven correct:

  • If you bought the stock, you made ¥1 million, or 50 percent.
  • If you bought the ¥2 million call now trading at ¥1.25 million, you made ¥0.75 million, or 150 percent.
  • If you bought the ¥3 million call now trading at ¥0.4 million, you made ¥300,000, or 300 percent.

Thus, provided the stock moves quickly in the direction anticipated, the gearing of warrants offers the chance for high capital gains. The downside is this gearing works both ways, and the chances of losing money are high. The more "out-of-money" strike you choose the higher the potential reward, but the likelihood of reaching the price is less.

The pricing and hedging of warrants is outside the scope of this article and is difficult to touch upon without getting into complex mathematical formulae. The evaluation of warrants is a highly technical process with numerous interacting variables and requires specialist knowledge and software.

To put it simply, call warrants' price will usually go up (and down) faster than the underlying stock. Warrants will cost more the longer they have to run and the higher the volatility of the underlying stock, since there is more chance the stock will reach the strike price at expiration.

If you are very bullish on a stock, you should usually buy the call rather than the stock because of the gearing, provided the warrant is relatively liquid, has a long time to expiration, and the implied volatility is not likely to drop steeply. If you are slightly bullish, you will need to do a cost/benefit analysis of the relative merits of the stock versus the gearing-positive/time-decay-negative of the warrant. If you are bearish, buying a put is usually less risky than an outright short.

Always remember that warrants expire. Such time decay becomes especially steep in the final month or so. A good way to reduce the effects of this decay is to never run them to maturity.

Gearing works both ways. You can lose the premium quickly if you get it wrong. Warrant prices can fall to near zero very quickly, especially as expiry nears.

For options and warrants, price information is much poorer, and you will probably only be able to get the price from the site of the issuing investment bank or Net broker. One stock can have hundreds of options based on it, by put or call, expiries and strikes, and you will have to choose the one that best matches your expectations.

Whilst there are efforts beginning to increase liquidity in these markets, when you buy a warrant, you are basically dependent on the same market maker to get you out. Most covered warrant issuers guarantee a bid-offer spread, but you will often be surprised by just how far away the buying back price turns out to be when you and many others head for the exit door.

Market manipulation. Yes, it does go on! And no time more than on option expiration days. Triple-witching hour in the US and, to a lesser extent, the Special Quotation in Japan is where all the large practitioners try to manipulate underlying stock prices to ensure that as many or as little as possible stock options expire favorably to them. You can rely on this being the opposite of what you would like. Hence, don't hold to expiry.

They are increasingly available online as well as through traditional brokerages. Active market makers in the Japanese covered warrants market include Goldman Sachs, Daiwa Securities, Citicorp, Credit Lyonnais, and Societe Generale, and this is expected to grow as the market develops.

Options and warrants are a complex and sometimes arcane area of investment, and in a short article it is difficult to cover everything. However, as tools for investors, they are well worth spending the time to get familiar with. With some Japanese stocks being issued and trading at multimillion-yen prices and the continued existence of daily price limits on individual stocks and minimum dealing sizes, such instruments are worthy of attention for all investors.

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