By now, readers should be familiar with the terms in-the-money (ITM), at-the-money (ATM) and out-of-the-money (OTM). These terms refer to where an underlying asset’s price is relative to a warrant’s exercise price. When picking warrants, it’s important not just to focus on whether an instrument is ‘cheap’ in terms of absolute price or implied volatility. It is also important to know how ITM, ATM or OTM warrants behave, so you can pick one that suits your time frame and direction.
In general, because an OTM warrant offers much higher gearing than the other types, it is a suitable pick if a sharp move in the underlying asset is expected in the immediate future. If this actually happens, the investor gains the maximum benefit of the higher gearing. But because warrant prices decay quickly over time, buying and holding an OTM warrant is not advisable. As such, these instruments are more suited to the aggressive risk-taker.
ATM warrants, on the other hand, offer moderate gearing and should therefore appeal to more conservative investors who expect a move in the desired direction in the medium term.
ITM (or deep ITM) warrants have much lower gearing and are suited to someone who expects the underlying asset to perform in the desired direction over a longer term.
Which to choose? Undecided investors are advised to go for the more conservative option of a slightly ITM warrant with plenty of time left to expiry. This option has the dual advantage of offering more time to play with, as well as upside if the underlying asset performs in the short to longer-term. Note, however, that there will be some loss of gearing benefit - ITM warrants have low gearing. Still, it’s better to be safe than sorry.
Once again, it’s important to stress the need for the investor to have a view on the underlying asset, and once this has been formed, to manage the risk carefully.
Two common mistakes that retail investors make is (a) to buy a warrant purely because it is cheap and (b) hold it too long, only to find out sooner rather than later that time has run out and the instrument is worthless.
A firm grasp of how ITM, ATM and OTM warrants behave is a good first step in avoiding such losses.
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How ITM, ATM, OTM warrants behave
1 December 2008
By now, readers should be familiar with the terms in-the-money (ITM), at-the-money (ATM) and out-of-the-money (OTM). These terms refer to where an underlying asset’s price is relative to a warrant’s exercise price. When picking warrants, it’s important not just to focus on whether an instrument is ‘cheap’ in terms of absolute price or implied volatility. It is also important to know how ITM, ATM or OTM warrants behave, so you can pick one that suits your time frame and direction.
In general, because an OTM warrant offers much higher gearing than the other types, it is a suitable pick if a sharp move in the underlying asset is expected in the immediate future. If this actually happens, the investor gains the maximum benefit of the higher gearing. But because warrant prices decay quickly over time, buying and holding an OTM warrant is not advisable. As such, these instruments are more suited to the aggressive risk-taker.
ATM warrants, on the other hand, offer moderate gearing and should therefore appeal to more conservative investors who expect a move in the desired direction in the medium term.
ITM (or deep ITM) warrants have much lower gearing and are suited to someone who expects the underlying asset to perform in the desired direction over a longer term.
Which to choose? Undecided investors are advised to go for the more conservative option of a slightly ITM warrant with plenty of time left to expiry. This option has the dual advantage of offering more time to play with, as well as upside if the underlying asset performs in the short to longer-term. Note, however, that there will be some loss of gearing benefit - ITM warrants have low gearing. Still, it’s better to be safe than sorry.
Once again, it’s important to stress the need for the investor to have a view on the underlying asset, and once this has been formed, to manage the risk carefully.
Two common mistakes that retail investors make is (a) to buy a warrant purely because it is cheap and (b) hold it too long, only to find out sooner rather than later that time has run out and the instrument is worthless.
A firm grasp of how ITM, ATM and OTM warrants behave is a good first step in avoiding such losses.
This column is brought to you by Merrill Lynch.
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