Since last week, we've been blogging about market volatility, and for traders who don't know how to trade short-term and intraday, we should stay away from the market.
Changing your trading approach is one way of reacting to a sideways market. However, changing the way we trade during a bear market doesn't help us keep trading profits. The only way to profit in the stock market is to change trading instruments. Instruments such as intraday short selling, futures, options or structured warrants. These are the only tools we can trade for profit during market declines.
However, these investment tools will have additional risks such as time decay and leverage on the underlying stock. Before we discuss when to trade and how to choose derivatives, we should understand the risks before we start trading.
What are Derivatives
Derivatives are contracts opened by third parties, such as investment bankers, based on an underlying security or asset. So, it's a deal between you and the investment banker. They make a profit by selling derivatives to you and taking the risk of the underlying securities against them.
If you think FBMKLCI will go down further, you buy a PUT warrant from an issuer (Investment Banks/ brokers) to lock the selling price of FBMKLCI at the current price. When the FBMKLCI goes lower than your locked price on the expiry date, you are at a profit. FBMKLCI is an index & is not a securities product, therefore, you don’t get any share certificate or any forms of ownership. The issuer will go into cash settlement on the expiry date. For cash settlement calculation please refer to the video below:
However, if FBMKLCI goes higher than your lock-in selling price, then you will be in the red. You can choose to cut your losses by selling the warrants to the market or hold to maturity, in which case holding to maturity does not make sense. The issuer will get the full profit from the price you buy the warrant.
Time decay is the rate at which the price of a derivative falls over time. Derivatives prices will fall faster as expiration is approached. Therefore, you cannot hold derivatives when they are very close to expiry. Even with the exercise price in the money, it will decline rapidly from 1.5 months before the expiry date.
Unlike buying stocks, you can still hold them for the long term. Typically, these derivatives are not older than 1 year. Derivatives are not your trading tool if you have "hold stock syndrome".
Derivatives are security products in which you can invest a smaller amount of capital and move in the same price as the underlying security. Therefore, derivatives will experience large price movements when the underlying asset price changes are small.
You can think of it as a gear mechanism, FBMKLCI is the bigger gear & the gear teeth are connected to the smaller gear that represents structured warrants or other derivatives. With a small movement in FBMKLCI gear, the smaller gear will have a huge movement.
However, some derivatives are structured less sensitively to the underlying security. Therefore, it is very important for investors to check the leverage effect of derivatives when choosing which derivatives to invest in.
Which derivatives shall we choose for our upcoming trades?
The only derivatives in Malaysia to trade for a down market are either the FBMKLCI futures contract or the FBMKLCI structure warrant. Both of these derivatives have the risk mentioned above, however, futures contracts incur another risk which is the margin risk & exercise risk. This means if you are not carefully calculated or didn’t understand the potential exposure to its unlimited losses.
Many investors approach futures trading because of the potential profits they hear from others. Another common reason we hear that many investors prefer to trade futures is that they only focus on one security. So, they will understand this behaviour more easily than in the stock market. But we always see some traders still ignorant of where futures prices are going and still relying on traditional analysis. Looking at risk itself is not easy because there are additional risks to deal with.
Therefore, we prefer to look at structured warrants that are less risky than futures, and we do not need to open a new futures trading account. We can trade structured warrants using our common stock trading account.
How to select structured warrants?
There are a few points we need to take note of in selecting the right structured warrants:
- Put / Call: Your expectation of the underlying asset direction.
- Exercise Price: The closer to the exercise price the more expensive it is.
- Expiry date: for trading choose something more than 3 months
- Effective Gearing: Higher gearing more sensitive to the underlying securities
- Liquidity: make sure you can sell at a price that is near to the last price.
Usually, points 2 to 4 should be provided by the issuer of the warrant. We normally go to https://www.malaysiawarrants.com.my/ for information on structured warrants issued by Macquarie.
You can view the buy and sell queue/depth of the market through your trading platform to understand the liquidity of structured warrants. If you find that the best ask price is 0.450 and the best bid price is 0.420, the price difference between the bid and ask prices is 0.030 cents. This is one of the signs that structured warrants are not liquid.
Another sign of illiquidity is the order queue at the bid price, with few orders stopping to absorb the selling pressure. Liquidity is important to ensure that we can close our positions as close to the current price as possible.
How do we know the market will reverse or continue to trend lower?
ALWAYS do your study in the underlying asset, do not study the price movement of the structured warrant. Because the derivatives price moves based on the underlying assets. For example, if you think FBMKLCI will continue to go lower, then you choose the structured warrants that fit your trade decision. It shouldn’t be the other way round.
Now that you have a basic understanding of structured warrants, the next step is to know when to apply them to the benefit of our trade. The timing of applying these trading tools is very important, and we don't want to trap ourselves with late entries.
We will share our own analysis as we apply these trading tools to understand whether the market is down or up through the big boys' trading data. This has been helping us improve the efficiency of our portfolio across all different market cycles.
This topic will be shared in our upcoming webinar below:
Title: Effective Trading In The Bear Market
Date: 20th July 2022, Wednesday, 8:30PM
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