Disclaimer: This article is written for the purpose of discussing my thought on a buy or sell process basing on a fundamental approach. It is not a recommendation to buy or sell any particular stock. This article was published in the private learning blogs before posting here.

In my article below. I have mentioned that I have two derivatives in the form of company warrants of MRCB and BIMB. As at the end of the year 2014, both of them were killers in MyThirdPortfolio and both have dropped by 36.4% in price since I wrote about them the last time, !@#$%&*.

http://klse.i3investor.com/blogs/kcchongnz/68248.jsp

And it attracted a few serious comments like this which I have to deal with too:

[Posted by jimmyfallow > Nov 20, 2014 06:20 PM | Report Abuse

bullchett, all kcchongnz buy call masuk longkang. bought 0.66 now look at the price. sifu from longkang.]

[Posted by donfollowblindly > Nov 20, 2014 09:29 PM | Report Abuse

Agree with jimmyfallow. How to retire comfortably if I have longkang stock like this(down 23% since his recommendation). So don't follow KC Chong tips blindly despite his sifu status in i3.]

Yes, that is right, don’t follow blindly. Nobody can be right about stock all the time. Even if he is right, the market may not agree with him for a time longer than you can be solvent. If you follow and lose money, you only have yourself to blame. But how did you come to the conclusion that all kcchongnz “buy call” masuk longkang? On the contrary, I see complete different stories as described here.

http://klse.i3investor.com/blogs/kcchongnz/67653.jsp

http://klse.i3investor.com/blogs/kcchongnz/68009.jsp

http://klse.i3investor.com/blogs/kcchongnz/68248.jsp

As far as I know, the first two portfolios posted in i3investor out-performed the KLCI by a huge margin with excess returns of 62% and 51% respectively over the market during the same period, and even the third portfolio with the two under-performing warrants was better than the broad market.

Anyway, let’s not worry about that as I have never asked people to buy whatever stocks so far but merely sharing of knowledge. We will focus on discussing and sharing why I have decided to keep those two losing warrants. We are getting into a more difficult subject in derivatives and option pricing now.

I mentioned that I would keep them in MyThirdPortfolio. Why not cut loss, the famous term in the stock market? Or is this some kind of cognitive bias in loss aversion? May be and maybe not. Let us revisit why I bought these warrants in the first place by referring to my previous posts below:

http://klse.i3investor.com/blogs/kcchongnz/58419.jsp http://klse.i3investor.com/blogs/kcchongnz/49210.jsp

For more information on warrants on the terminology, premium, gearing etc, please refer to the above posts. They also provided an introduction of how warrant is priced using the Black-Scholes Option Pricing Model. Let’s use one of them, BIMB Wa as an example.

BIMB Wa

Let us look at the profile of warrants of BIMB Wa below as on 16^th January 2015.

Share price of BIMB, S:                  RM3.99                

Share price Wa, W:                          RM0.440

Exercise/Strike price, X:                  RM4.72

Expiry date:                                         04/12/2023

Conversion ratio:                             1 for 1

The computations of the properties of the warrants as shown below:

Intrinsic Value of BIMB Wa = Max[0, S – X ]= 3.99  – 4.72 = 0

The warrant is hence way out-of-the-money with zero intrinsic value.

Premium P = (W + X ) / S – 1

P = (0.44 + 4.72) / 3.99 = 29.3%

Gearing of Wa = 3.99 / 0.44 = 9 times

The premium now is 29.3% as computed. The value of Wa is purely in its time value of 44 sen given by the market. The gearing is 9 times which is reasonably high. Hence Wa still appears to be a good alternative in investing in the business of BIMB with a reasonable premium and a high gearing.

Option Pricing of BIMB

We have discussed about the option pricing of BIMB Wa in the following post before.

http://klse.i3investor.com/blogs/kcchongnz/49210.jsp

The previous computation of the OPM of BIMB has the following conclusion:

“With the underlying share price at RM4.23, exercise price of RM4.72, 9.7 years to maturity, a dividend yield of 1.7%, risk-free rate of 4% and a historical volatility of BIMB at 29.5%, the option value of Wa is RM1.41. This shows Wa at 66 sen, is apparently trading at 53% undervalued.”

Now that the prices of the underlying share and the warrant are now RM3.99 and 44 sen respectively, and there is a time decay of about 9 months, is Wa still an attractive investment?

Plucking in the new prices and the new date now into the OPM spreadsheet, with 9 more years to maturity, a recent dividend yield of 3%, and using the same historical volatility of BIMB (I somehow could not get the recent daily price data from Yahoo Finance), the option value of BIMB Wa is found to be 96 sen. This means Wa at 44 sen now is trading at a discount of 54% to its option value.

The implied volatility, by forcing the warrant value equals to its market price, is only 15%, a relatively low value which signifying a cheap price for Wa.

Payoff for BIMB warrant

Table 1: Payoff of Wa

Table 1 above shows the payoff for Wa for various price of BIMB before expiry of the warrant.

If the price of the underlying share does not move above RM4.72, the exercise price, when Wa expires, it will be worthless. Your initial outlay is the limit of your total loss. However, if BIMB share price moves up by 75% to RM7.00, Wa will move up by 418%, more than 5 times the gain in the underlying share. That is the power of leverage of derivative.

Figure 1 below depicts the payoff of Wa at different price of BIMB. Note that it has a long period of 9 years to wait for the price to move.

Figure 1: Payoff for underlying share and warrant of BIMB

Warrant for speculation

Let’s say we know the company’s prospect well and think that its share price can go up to RM7.00, or by 75% within this 9 years. We have RM39900 to invest in 10000 shares of BIMB at the present price of RM3.99. If the share price goes up by 75% which I think is not a very difficult task with a 9 years of time frame, our return will be RM30100 as shown in Table 1 below.

Table 1: Expected BIMB and Wa share price movement and gain within 9 years

What if we utilize the RM39900 capital to speculate on 90700 shares of Wa at 44 sen? You can see that if BIMB goes up to RM7.00, the intrinsic value of Wa would be RM2.28 (7.00-4.72). You can convert Wa to BIMB shares and sell it in the market for RM7.00 and realize that value. You would gain 167000, or 418%. This is more than 5 times than investing in the underlying share. This is due to the beautiful gearing of 9 times investing in warrant in a bull market.

Here we are talking about what if the share price goes up. What if the share price goes down? The warrant holders would lose 4 times more instead. Why so greedy?

Warrant investment as a financial risk management

In investing, we shouldn’t always think about how much killing we are going to do. We should do inverting in our thinking; how much we are going to avoid losing if we are wrong?

Say we don’t want to be greedy aiming to make RM167000 but just RM30100 as investing in the mother share as above but using warrant now instead of using a large sum of RM39900 investing in BIMB shares. I would buy 16400 shares of BIMB Wa at 44 sen for RM7216. If BIMB share price goes up to my expected price of RM7.00, the intrinsic value of my warrants would be RM37392 {16400*(7.00-4.72)}, and I would still make RM30100 (37392-7216). However, if the share price of BIMB tumbles to RM1.00 due to unforeseen circumstances, instead of losing RM30000 investing in the mother share, I lose only RM7216 in Wa, the maximum of my exposure which is more bearable.

Conclusion

BIMB Wa, with a long time of 9 years to expiry, is trading at an undemanding valuation in terms of premium of 29.3% and implied volatility of just 15% compared to its historical volatility of 29.5%. Furthermore, it has a high gearing of 9 times which would greatly amplify the gain if the underlying share price goes up before the expiry date. Hence, if you believe in a company like BIMB as an investment, Wa at 42 sen now is definitely provide an excellent investing opportunity.

Company warrants can be used for speculation or investing with financial risk management. Its best use is the later  by limiting one’s maximum exposure in the event of severe downturn of the stock market as shown. This fits the safe investing strategy of the Dhandho Principle:

“Heads I win; Tail I don’t lose much”        Mohnish Pabrai

What about the other warrant in MyThirdPortfolio, MRCB Wa at a price now at 20.5 sen when the underlying share is RM1.33 at the close on 16th  January 2015? Well you would be able to evaluate yourself by learning through my online investment course. There are simply too many investment thingy you can learn from the course. For those who are interested to participate in this for a small fee, please contact

ckc13invest@gmail.com

Without having some knowledge of financial statement analysis and valuation, one simply won’t be able to know if a stock provide a good investment opportunity or is it a trap set up for you.

K C Chong (20/1/15)