Our Guide & Checklist to Trading Call Warrants - Year of the Rat Edition

This post first appeared at The Pelham Blue Fund, the premier day trading blog for Malaysia stocks and warrants.

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 When searching for call warrants in the wild, bring binoculars. Source

Last Updated : 10 January, 2020

There are hundreds of call warrants on Bursa Malaysia now. Even if you are the most sensible value investor in the country, you should still have a look at them as a viable way to express your market views.

Call warrants are many things, but they do not exclusively belong to speculators and those with an inclination to get poor quick (although most of the time this is what happens to speculators).

To mitigate the odds of making mistakes - you will make them, but hopefully under very strict parameters - you will need a guide. 

Trading warrants is more than just chasing a trend. You can be reactive (following the herd) as well as proactive (letting the herd follow you).

Contrary to popular belief, call warrants are usually issued to highly reputable and highly profitable companies. They can be speculative instruments, but they should not be compared to penny stocks where syndicates are just waiting to tempt you into parting with your money. You know which ones; we don't need to tell you.

In this post, we will share a list of important parameters and characteristics, broadly covering three aspects:

1) The call warrant identification stage : choosing the best one.

2) The 'mother share' fundamentals filter : things to watch out for when identifying a company to trade. This is supposed to complement your number crunching and typical fundamental analysis activities.

3) Managing the trade : this is about setting parameters. You have to control the trade, or the market will do it on your behalf with terrible results.

CALL WARRANTS ARE A FILTER FOR GOOD COMPANIES

We like call warrants as they tend to be a very good filter of the best companies (to trade) on Bursa Malaysia in the present. 

Investment banks that issue these things have to be choosy when it comes to picking a company to attach their call warrants to. Among the basic criteria for a company to qualify for a call warrant issuance, as far as we are are as follows:

1) The company must have an average market cap of above RM1 billion over a period of three months. This is especially important for small/mid cap companies whose market value has just exceeded that mark. Among the popular issuances in recent months include call warrants linked to DAYANG and DSONIC.

Incidentally, having new call warrants mark these companies as 'tradeable' stocks in the market. 

They have hit that RM1 billion mark and they stand a chance of maintaining that mid-cap classification, which then allows local or foreign institutional funds with such a mandate to buy into them. Obviously that would be very supportive of price and momentum.

2) There must be substantial trading interest in the company or sector. This happens when the company suddenly starts reporting strong quarterly earnings, or if the sector suddenly emerged as a favourable one. Examples are tour successes in PENTA and GCB, which we happened to get into early. We were among the very first buyers of their call warrants on the day they were issued.

3) It must be reasonably easy for the issuer to conduct market making activities and to hedge its exposure to the call warrant's underlying stock. Market making means the automated buy and sell queues that you see in the warrant every day : the spreads must be tight and they must reasonably reflect real prices; otherwise nobody will trade the call warrant. Note that issuers typically do not take a directional position associated with the call warrant; they only hedge, and make a market.

4) It most likely reflects the market's prevailing biases. Hey, it's just supply and demand. I offer a product that I think you will buy and make me profitable. That's why the leading counters and sector leaders have a shit-tonne of call warrants linked to them.

Everybody and their grandmother has an opinion on Proton now; that's why DRB-HICOM remains so popular. If you can think of a stock that's arguably getting 'hot', rest assured there is (or will be) a call warrant to trade. It's a natural filter for good companies and good stocks.

Also, if you're new to call warrants, here's a crash course before we get into the details. Credit to Macquarie, who are far and away our most trusted and reliable warrants issuer in this country.


https://www.youtube.com/watch?v=j7GRXqdUeLk&feature=emb_title

THE TRADING GUIDE AND CHECKLIST

Note : A checked item does not necessarily mean it is good for trading. It's just the little things to care about when you're looking for a good call warrant.

SECTION ONE : THE CALL WARRANT IDENTIFICATION STAGE

• (  ) Is it one of the first call warrants to be issued for this presumably promising company? (Good if it is; it may mean the company is emerging as a favourable stock from both the fundamentals and technicals perspectives)

• (  ) Is the mother share priced at RM3 and above? (Stocks above this price point exhibit more volatile price fluctuation characteristics, which makes it good for expressing a short term viewpoint.)

• (  ) Is the call warrant less than a month old? (Good if it is. You might be among the early ones to identify it as a good trading prospect.)

For the following items, refer to our other post on choosing the right call warrant as a guide. It explains why we look at these traits.

•  (  ) In terms of liquidity, volume and price, is it the best call warrant available?

• (  ) Was there a previous disconnect between the call warrant and the mother share due to some short term event? (Better if there was none)

• (  ) Is the call warrant cheap in absolute terms?(It should typically be anywhere between 9 sen and 20 sen; this is our personal preference. Cheap enough to accumulate a large position, and attractive enough to entice the herd)

• (  ) Has the warrant undergone a slump due to a recent weakness in the mother share price?(Better if there was none. An easy example is the usual post earnings decline for strong momentum stocks. Even if earnings were fantastic, there is a better than average likelihood of profit taking at this point. This can seriously hurt the call warrant's value, of course)

SECTION TWO : THE MOTHER SHARE FILTER

 When the mother share is a good one, the call warrant will grow up and become exemplary children

• (  ) Is this the best company in its sector? (This typically means that its shares tend to outperform peers)

• (  ) Is the sector within your sphere of competence?(No matter how good you think you are, you're never going to know all the sectors all the time. Stick to what you know best, perhaps a sector in which you have demonstrated an ability to make profitable investments from fundamental analysis)

• (  ) Are the dynamics of the sector easily understood? (For example, the earnings prospects of glovemakers, manufacturers are relatively easier to analyse from a short-to-medium term perspective. Conglomerates, tech - not so much)

• (  ) Presumably the stock has a catalyst. Can you attach some solid, actual figures to it? (Determine if the recent moves are facts based or sentiment-based. Either one is OK, but you need to fully understand why it moved, and why it may not continue to move at some point)

• (  ) Is this sector beating the broader market? (Very important. It means the company will outperform the market during good times. During bad times, assuming the catalysts are intact, the company will not decline as much as the FBM KLCI itself)

• (  ) Would this sector story/theme last beyond a single quarter? (Better to identify long term themes. An example is the recovery in the poultry segment last year)

• (  ) IS THE STOCK FLIRTING WITH A PRICE BREAKOUT SOON? (Very important. it's a gauge of the existing enthusiasm in the stock. Most of our TradeOfTheWeek posts contain examples of price breakouts)

• (  ) Market beating profit margins? (This must not be hard to explain or a result of a one-off gain. It must be fundamentals backed)

• (  ) Market beating revenue growth? (Relative to sector peers and broader market)

• (  ) Net asset value (NAV) growth on a year-on-year basis? (This shows that the company's earnings was not diluted from rights issues, for example. Long term business growth supports the case of long term positive momentum for the stock)

• (  ) Is it nearing a dividend or rights ex-date of some sort? (This may mean that the recent momentum is because of some interest in shares acquisition before the ex date; it's not a good sign since the trade is supposed to be fundamentally oriented)

• (  ) Is it a stock in a previously unfancied sector? (This may offer higher upside potential, particularly is there an earnings recovery theme)

• (  ) Is it a contrarian or conventional pick? (Contrarian picks offer higher upside potential but you may have to wait longer, leaving your call warrant vulnerable to time decay)

• (  ) Is it gaining momentum pre-earnings or consolidating/gaining new momentum post-earnings? (Important to factor in the short term cyclical nature of momentum stocks)

• (  ) What is the MAJOR SHIFT that could propel the company to greatness? (Always better to list down and properly articulate what the catalysts are)

• (  ) Is the stock clearly undervalued by most fundamental measures? (Good if it is. But it's also important to have the right call warrant)

SECTION THREE :  MANAGING THE TRADE ONCE IT HAS BEEN MADE
This is where you have to do periodical checks on your position. Don't get married to an idea; base your thinking on facts, not presumptions.

• (  ) It's been a few days/weeks. Is the stock still trading within 5% of its recent highs? (This is a gauge of whether the trading interest in the stock is sustained)

• (  ) Is there a sensible time loss or stop loss for capital preservation purposes? (Always have these and follow them strictly; no room for flexibility if you want to avoid severe losses)

• (  ) Was the position fully accumulated at the start or is there room to build up on it? (This is an indicator of confidence at the start of the trade. Never acquire more shares when the position is showing a loss)

• (  ) Can you withstand a 1.5-2 months' slump in the stock price? (No big deal if you can afford to buy and hold the stock. But if you buy call warrants, this can be fatal. Use this is a variation of the time stop; sell if the position is not showing any profit after the timeline is up)

• (  ) Is there another call warrant which is exhibiting better characteristics? (This implies that your original choice was wrong. Some call warrants outperform others)

• (  ) What is the deadline for this trade to show profitability? (You can be right and still lose money if your timing is wrong. If you're not profitable by this date, cut)

• (  ) Have you missed an opportunity to take profits? (Call warrants are volatile by nature. If your paper profits evaporate completely, don't try and hope for a recovery in prices. Acknowledge your mistakes and sell the position. The paper profit essentially validated your trading thesis. When it's gone, you're no longer operating within the same parameters)

And that's it. Try to think rationally and always detach your ego from the trade. Know your limitations and don't waste time things you can't control. Keep the decision making to yourself; never let the market do it for you.

We wish you a good trading year ahead.

https://klse.i3investor.com/blogs/pelhambluefund/2020-01-12-story-h1482125181-Our_Guide_Checklist_to_Trading_Call_Warrants_Year_of_the_Rat_Edition.jsp