Warrants: Tips for using the “Greeks”

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  Serge Nussbaumer
  Chefredaktor

The so-called “Greeks” are mathematical variables that describe the sensitivity of the price of a warrant to changes in various influencing factors. They are helpful in understanding and managing the risk and price changes of warrants. Today it is not about definitions, but about concrete practical tips. A certain basic knowledge is therefore assumed. If you would like to find out what the individual “Greeks” mean, you will find the relevant explanations in the report “Warrants: keeping track with the ‘Greeks'” in the August issue of payoff magazine.

Delta: Understanding the lever correctly

When trading warrants, many investors only pay attention to the simple leverage – this is a mistake. This merely indicates the factor by which an underlying asset is more expensive than a warrant. For example, if a share costs CHF 100 and a warrant based on it costs CHF 10, then the simple leverage is 10 (with a subscription ratio of 1:1). However, this calculation does not take into account the sensitivity of the warrant to changes in the price of the underlying. The effective leverage, also known as the omega, provides a better indication of the leverage of a warrant. This is calculated by multiplying the simple leverage by the delta. The following applies: if the delta of a warrant is high (0.8 to 1.0 for calls; -0.8 to -1.0 for puts), then the security reacts almost like the underlying in absolute terms. If the delta is low (0.1 to 0.3 for calls, -0.1 to -0.3 for puts), then the warrant hardly moves at all when the underlying asset moves. This results in the following rules of thumb: If you want to trade fast, clear price movements, you should choose warrants with a delta of greater than 0.5 (for calls) or less than -0.5 (for puts). If you want to take a more relaxed approach to a trend idea, opt for warrants with a delta between 0.3 and 0.5 (for calls) or between -0.3 and -0.5 (for puts). Important to know: Like all Greeks, the delta is not a constant value, but changes over time (e.g. due to changes in the price of the underlying).

High gamma with strong movements

The gamma indicates how quickly the delta changes. The gamma is high for short (remaining) terms. This means that if the price moves in the right direction, the delta increases and the bill becomes more aggressive. High gamma bills are well suited for trading in order to take advantage of turning points. They should be avoided when the market is moving sideways.

Vega: profiting from volatility

The vega indicates how strongly a warrant reacts to changes in the implied volatility of the underlying. As a general rule, if implied volatility rises, warrants become more expensive, all other things being equal – regardless of whether they are calls or puts. If, on the other hand, implied volatility falls, the reverse is true. This influence of volatility can be used in practice. Example: If the volatility of the underlying is low before important events such as interest rate decisions or quarterly figures, but at the same time strong price swings are expected as a result of the event, it may make sense to position yourself in advance with warrants with a high vega.

Example of a Vega trade

Let’s assume that a company’s quarterly figures are disappointing and the share price falls by 10% from CHF 50 to CHF 45. As a result, the expected volatility of the share skyrockets from 20% to 35%. Further assumption: an investor has recently bought put warrants with a remaining term of 180 days and an at-the-money strike price of CHF 50 (subscription ratio 1:1). Background: Warrants that are at the money and have a relatively long remaining term have particularly high vega values. After the price slide, investors can be doubly pleased. His warrant not only gains from the fall in the share price, but also benefits from the increase in volatility.

More profit through Vega effect

Based on the above assumptions, the put warrant has a fair value of CHF 2.56 according to the Black-Scholes option pricing model before the fall in the share price. After the fall in the share price, the fair value of the put warrant soars to CHF 7.24. The gain is therefore 183%. The gain is therefore 183%. But how strong was the Vega effect in this scenario? This is shown by an alternative calculation without taking the increase in volatility into account. In this case, the value of the put would only have increased by 115% to CHF 5.50. The example shows that a high vega can make a considerable contribution to the total return of a put in the event of vola jumps. In this case it is an impressive 68 percentage points. If, on the other hand, the investor had positioned himself with a call, he would have been caught on the wrong foot, i.e. his warrant would lose value as a result of the share loss. However, this would at least be offset by a positive volatility effect on the price of the call.

Attention: Loss of time value

Finally, a brief word on theta, i.e. the loss of time value. Basically, the higher the
theta, the more expensive it is to “wait”, with the loss in value becoming greater the closer the expiry date approaches. Here is a guide: with remaining terms of more than 90 days, time hardly plays a role; with remaining terms of between 30 and 60 days, the time value drops noticeably; with less than 20 days, time “eats” the price very quickly; with less than seven days, a bill can even lose value despite the right direction.

Four key points

– Delta decides how quickly you win or lose money.
– Gamma amplifies movements – good for trends, dangerous sideways.
– Theta eats appearances – time is an enemy.
– Vega decides whether to buy cheap or expensive.