Friday, August 12, 2011

Death Warrants

A painfully long post about a painful trade and an attempted recovery.

I could write pages and pages on warrants,what they are, how they work, why I use them, why they are stacked aginst us, why they tend to destroy wealth ! and knowing that - why do I still use them ?

For now I will just outline the current trades RG56 and RI29

RG56 is a bet on the FTSE Rising.

RI29 is a repair trade trying to recover some of the damage I took on RG56.

I bought RG56 at 28p hoping to profit from a bounce in the FTSE following its recent sharp sell off. There is a saying 'Dont try to catch a falling knife'. This was a 'Catch a falling knife' trade. The FTSE carried on selling off and I ended up bloodied as a result. Having bought in at 28 I sold the position for 17.8 for a total loss of 36%. At one point my loss was over 60%, only a trader can look at a 36% loss and consider it a comparative success.

I could have held on to the position through to today, as I type RG56 is at 23p.

RG56 September FTSE Call at 5250

Instead I took the decision to move the position expiry further out, RG56 expires on the 15/09/2011, as a warrant gets closer to its expiry so the time value component decays at an accelerating pace. By moving the position further out I am able to maintain my bet, while not suffering guaranteed losses through time decay.

To give some perspective the entire 23p value of RG56 is made up of artificial factors that will decay over the next 22 days, if the FTSE is not above 5250 on the 15th September RG56 will expire worthless.

You can see the effect of time on the warrant price using the calculator on the right of the screen in the links, RG56 loses 2% per day, RI29 loses 0.5% per day.

Back to the trade, I sold RG56 and reinvested the remaining capital in RI29, this is again a FTSE Call option with a strike price of 5250, however the expiry is three months further out at 15/12/2011 reducing the effect of time decay.

RI29 December FTSE Call at 5250

This is a flawed repair trade, my original trade in RG56 was for 20,000 units giving equivalent exposure to -

20,000*0.001*5,250 = 105,000 GBP. (Actual cost 20,000 * 28p = 5,600 GBP)

As I got beaten up on this trade I didn't want to replicate the same level of exposure in the new position so only reinvested my remaining capital allowing me to by 11,400 units of RI29 -

11,400*0.001*5,250 = 59,850 GBP. (Actual cost 11,400 * 31p =  3534 GBP)

As my equivalent exposure is roughly halved I need the market to move up twice as far to repair the damage from my original RG56 trade. I don't expect this to happen.

Although RI29 is as I type up to 33p from the 31p I bought at I am not at all commited to this trade, I will continue to evaluate this one, currently my options are -

1) Do nothing - Hope that we are just in a summer slump and that FTSE will rally back over 5,500 into the autumm.

2) Sell today - Lock in the 228 GBP profit since last night to offset against the 2,400 GBP Loss on RG56

3) Hold and 'Double Down' on any dips

My inclination is option 3) To recreate my original exposure I need to buy 8,600 more units of RI29, I would rather wait for the market to fall before doing this. If I dont get this opportunity I will default to option 1) for now.

In an ideal world I would like to skip RI29 altogether, if FTSE drops 5% to go below 5,000 I would be agressive in buying calls at a 5,000 strike.

To understand warrant pricing there used to be a very accessible online guide to published by Society Generale, when I find it I will post it, in the meantime here is this far less engaging effort from the London Stock Exchange -
London Stock Exchange Guide To Covered Warrants

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