Friday, August 19, 2011

Heads You Lose, Tails You Lose.

The market has fallen steeply for two days, by around 9.30 this morning the FTSE was nearly 8% lower than the close on Wednesday, thats 8% in 10 hours of trading.

8% Fall From Wednesdays Close to 9:30 AM Friday

A rapid sell off such as this often presents the opportunity to take a quick profit by exploiting any intraday bounce off the morning lows. One way to gain from a bounce would be to use a leveraged product such as an option contract or a warrant to magnify the size of the bounce. Many warrants are available to retail investors offering leverage from 4 to over 20. Leverage essentially allows you to magnify small intraday movements so that a 1 percent bounce can lead to a 4, 5, 10, 20 % or more bounce in the leveraged product.

While examining the range of warrants available to make an intra day trade this morning, something interesting happened. The warrant RI29 which follows the FTSE 100 index of shares in London initially opened significantly lower, down from last nights 26p to a low of around 21p.

This looked like a good entry point to play any rally in the FTSE back above 5000, however while examining the full range of options to make this trade, the FTSE turned another leg lower. This action would be expected to drive the price of RI29 down even further.

It didn't. Against expectations, RI29 actually increased in value recovering from its 25% loss to trade back around 26p. Initially this does not appear to make sense, FTSE dropped further yet the contract which follows FTSE and should have dropped even lower actually gaped significantly higher. So what happened ?

RI29 is a call warrant, that means you are effectively buying the FTSE, when the FTSE rises the value of your call rises. Another type of warrant is a put warrant. A put allows you to sell the index, you might sell the index if you expect it to fall in value, if I sell it today (buy a put) and the index falls tomorrow, I profit by the difference, the profit comes in the form of an increase in the value of my put which at some point in the future will payout the difference between its strike price and the now lower FTSE.

RI41 is a put warrant, whenever the Ri29 call is rising in value this would suggest that the FTSE Index is rising in value and RI41 should be falling. This morning both RI29 and RI41 moved sharply higher together.
How can that be possible ? The index is either up, or down, it cant be both, can it ?

No, the FTSE index is just a value calculated from the current prices of a selection of shares traded in London. So how could two products that are designed to move in opposite directions, both move sharply in the same direction, was something broken ?

In a way yes, something was broken. For a short period this morning, it appeared as if the spirit of the market had broken, look at the chart at the start of the post, down 8% in ten hours, and which way is it heading still ? It looked as if the market might plummet again today and on this basis the measure of market volatility increased sharply.

Volatility is often termed the 'fear gauge' its a synthetic calculated value designed to provide an indication of how large market movements might be in the short term. When the FTSE Broke below 4950 to trade as low as 4938, fear took over and volatility exploded higher.

Options contracts and Warrants include volatility as a coefficient in their pricing calculations, in the brief period of outright fear, volatility increased from 29.59 to 34.31, this caused the price of RI29 to recover its initial lose of 25% and run all the way from a low of 21p up to 29 to now trade at a premium of 11%. This entire 36% (40% if you caught it at 21p) swing in price occurred even though the FTSE Was dropping and
could at first glance be expected to crash the value of RI29 as it initially did.

Sample Price Simulation For RI29, FTSE Lower, Volatility Higer, Value = 27p

So if the value of the warrants is increasing regardless of whether you take a position on the market rising or falling, surely its a one way bet, Heads I Win, Tails I Win ?

No, in fact its actually the opposite. The market is now rallying off the lows as predicted. You might expect RI29 to deliver a nice profit based on the rising FTSE however this is almost guaranteed to be a losing trade for the rest of the day. The problem is that a high volatility value is now included in the warrant price, as the market rises which is the action we would hope to profit from, the volatility component will fall back. This is guaranteed to limit our gains and could easily lead to significant loses even though we had correctly anticipated the market direction and positioned accordingly.

Sample Price Simulation For RI29, FTSE Higher, Volatility Lower, Price = 23p

End result, no trades today, Heads You Lose, Tails You Lose.

Note, to access the price simulations shown here, visit RBS Markets UK in the search at the top left of the screen enter RI29 or RI41. This will show the summary page for the given warrant, on the right you will see the basic price simulator, under this is an option to access the advanced simulator shown in the post.

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