Making money in a downtrend

Malaysian Business, Mar 16, 2007 by Alan Voon

WITH THE equity market falling sharply from a high level recently, market participants in many jurisdictions had the opportunity to benefit from buying put warrants on stocks and indices. Unlike call warrants where buyers bet for a rise in the share price, investors of a put warrant hope for the underlying price to fall in order to make a profit.

However, put warrants are not available in Bursa Malaysia just as yet. Even though the authorities have already re-introduced short selling in Malaysia, the Securities Commission has not come up with guidelines for the issuance of put warrants. If put warrants were available, investors in Bursa Malaysia would have an arsenal of weapons to choose from to benefit from all market conditions.

The following example illustrates how an investor would be able to benefit from a fall in the share price of an underlying security by buying put warrants:

Bursa Malaysia share price : RM10.00

Bursa put warrant A (Bursa-PW) : RM1.00

Bursa-PW exercise price : RM9.00

Exercise ratio : 1 for 1

Expiry : 7 months

When the stock market fell rapidly in the beginning of March, Bursa Malaysia's share price was trading at about RM10.00. Investment Bank A had issued a put warrant on Bursa Malaysia at an exercise price of RM9.00 at an exercise ratio of 1 for 1. If an investor had bought into Bursa-PW, he would have been able to make money (in-the- money) had Bursa's share price fallen below RM9.00.

Mr B bought Bursa-PW at RM1.00, as he predicted significant downside for the share price. As Bursa's share price was RM10.00, the warrant was not worth exercising.

Had the stock market fallen in the following few weeks and the share price of Bursa dropped to RM7.00, Mr B would have been able to profit from buying Bursa-PW. This is because then, Bursa-PW would have an intrinsic value of RM2.00, this being the difference between the exercise price (RM9) and the current share price (RM7). If Bursa- PW was an American-style warrant, where holders can exercise it at any time, Mr B could submit the exercise form to Investment Bank A at any time to get a gross profit of RM2.00. As the cost of Bursa-PW to Mr B was RM1.00, he would make a profit margin of 100%.

Further, had Mr B utilised the short-selling facilities, he would have made RM3.00, this being the difference between the market price of Bursa's share during the two periods. Mr B would only make a 30% return that way.

But Mr B does not need to exercise Bursa-PW prior to its expiry date of seven months. As Bursa-PW is traded on the exchange and its share price is quite volatile, it is likely that Bursa-PW would have significant time value in addition to intrinsic value. If Bursa-PW was trading at RM2.70 when Bursa's price fell to RM7.00, which is not an unreasonable assumption, Mr B would have made a profit of 170%.

Let's hope Bursa Malaysia introduces put warrants into the Malaysian market soon.

Alan Voon is the Chief Executive Officer of Warrants Capital Sdn Bhd, a derivatives specialist education provider. He is the author of `Make Money Investing in Warrants on Bursa Malaysia'.