Time Decay

The price of an equity warrant is the sum of the time component and the intrinsic value. The time component, also known as the premium, is representative of the market’s expectation up to the time of expiry. This expectation will fluctuate up or down with the passage of time, sentiment in the broad market and price movements in the underlying financial product.

Technical analysis can be used to track broad market sentiment and price movements in the underlying financial product. However, the warrant trader must be aware of the effect of time decay on the warrant as well. The effect of time decay can be observed in the following chart of a warrant that is ‘Out of the money’ and the broad market sentiment is flat.

The price activity in the above chart does not reflect any intrinsic value or positive/negative market sentiment. It can be seen that the price activity drops rapidly at first and then levels off. Also note that this warrant appears to have liquidity problems and is not running.

When a new warrant is issued the warrant issuer demands a premium for the warrant and this premium is discounted rapidly with the passage of time.

Liquidity

The volume of trading in the warrant market can seriously hinder entry, exit and stop loss execution. The volume behavior of a warrant is linked to the underlying share price as shown in the following illustration.

As price moves from ‘Out of the Money’ towards ‘At the Money’ the volume rises sharply and reaches its peak just beyond the point of being ‘At the money’. Liquidity is at its worse when price is deep ‘Out of the Money’ and will slowly deteriorate the further it moves ‘In the Money’.

Important Points
• Enter warrants when they are just 'Out of the Money'.
• Exit warrants shortly after moving beyond 'At the Money'.
• Liquidity in the warrant market is generally poor when the broad market is moving sideways and not trending either up or down.
• Warrant volume will follow the above curve in either direction.
• When following a trend; roll up through progressive exercise prices.
• Never buy parcels of greater size than those in the 'Depth of Market'

Risk and Money Management Considerations

Determining entry, exit and stop loss points is done by applying technical analysis to the underlying shares price activity. The risk and money management parameters are then taken from the warrants corresponding price activity. This method assumes that the price activity of the warrant and its parent have a linear relationship (ie. Time decay is ignored).

Numeric Example
The following chart shows the price activity of Telstra with the corresponding price activity of a Telstra call Warrant. The price of Telstra has broken away from recent lows at $7.50 and the exit point is set by the recent high at $8.50.

• Stop loss price is 0.74 based on corresponding Telstra price of $7.50.
• Exit price is 1.20 based on corresponding Telstra price of $8.50.
• Probable entry at 0.83 based on closing price of the warrant.

Conventional risk and money management techniques can now be used. Be aware that warrant price movements will often 'Gap' over stop loss levels. This problem is created and/or exacerbated by warrants that have poor liquidity.

Read more articles by Alan Hull.

Read more articles by Stock Investor Journal.

Get data to assist you in your active investing.

Published: 15 April 2005 - Copyright © Alan HullThis document is copyright. This document, in part or whole, may not be reproduced or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning or otherwise without prior written permission. Inquiries should be made to Alan Hull on phone +61-03-9778-7061 or via e-mail at enquiries@alanhull.com. This article needs to be viewed as educational reference only. It is not intended, nor is it to be regarded, as investment/securities advice or any other advice.