How viable is this approach with warrants?

I plan on purchasing extremely cheep OTM warrants (american style) of the Spanish Index.

Current price of the index is hovering around 12000-12100.

The trend seems pretty bullish.

I plan on buying 1000 euros worth of extremely cheap call warrants with a strike price of 14000 for the index at 16th March 2007.

Ask Price per warrant is 0.09 euro. With a delta of 12.13% and an elasticity of 15.38%. Implied volatililty is 16%

I could roughly buy around 11,111 warrants.

Today, the index is trading at lower than previous close. The call warrants are therefore undervalued & cheaper to buy today.

I also expect the index to pick up tommorrow.

So say the ask price tommorow increases to 0.10 euros. That is a 11.11% return on my investment in one day.

If the index continues to decline and the warrant trades against my position, I shall hold onto it for longer (ie. not sell it tommorrow). I don't feel the odds are that bad because support is present at 12000 points. Should I be forced to exit my position because of continuous undervaluing of the warrant, I shall quit when the ask price quotes at 0.07 (or a 22.22% loss)

How bad is this noobish strategy? Are the risk management, entry & exit positions reasonable? Opinions / critiques highly welcome.

Thanx.

Chirag

 

Underlying currently trading at 12045.

Ask price has gone up to 0.10.

If today / tommorrow the index trades higher it can easily go up another notch, so that means I get a 11.11% return on my capital in less than a day?

It can't be so simple.. or is it?

 

The warrants are cheaper, yes, but not undervalued! Undervalued means mispriced!

Don't forget about the bid ask spread! If you buy at 0.09 today and tomorrow the warrants are 0.09 bid 0.10 ask then your profit is zilch, cause you have to sell at the bid!

This strategy is not bad or good. Buying deep OTM options/warrants only makes sense when you feel really strong about the direction, so if you are a good direction picker then go ahead and buy it. But don't forget the leverage works both ways!

 

Sorry I meant CHEAPER not undervalued. Thanx for correcting.

I also realize I have to cover the bid ask spread. So basically I need a 0.02 increase to see profits.

I am strong about the bull trend. Today's pullback only means that I can buy long positions and calls at a cheaper price than if the market was up today.

So the cheaper I can get the warrant today, the higher the chances of me making a profit tommorrow when the index resumes the major upwards trend?

Do I have to be concerned about the elasticity (15.35) and volatility (16.00)??

Is this a very childish / risky way to expose myself to the market? Any way to cover or protect myself from the implied risk?

Like you said, leverage works both ways!!

 

Not really, just because the index goes down today doesn't mean that it is more likely to go up tomorrow, unless you have some evidence to support this claim. So the index can go down today, tomorrow and the day after tomorrow and each and every time you will lose money.

As I said, unless you're a good direction picker, i.e. have some system worked out that gives you a positive edge, this trade doesn't provide any edge in itself.

Elasticity is just the result of your choice of the warrant (i.e. deep OTM) so there's nothing to worry about. In fact, that's where the money is made when the index moves your way.

Volatility is a different story. Since you're long a call you are also long volatility, i.e. long Vega. So you're vulnerable to drops in volatility. That is, the index may go up, but at the same time volatility may go down, in which case the warrant may not change in price at all. It is not uncommon to not make or even lose money in options even if you get the direction right.

I don't know how much you know about option/warrant pricing, but you should definitely spend some time learning the basics (what moves the options, how they move and why) before trading them.

 

As far as I know, here in Spain, your warrants' position can only be long.

I.e. you cannot short them nor sell more of them than what you own.

I believe then, that there is no possibility to be short volatility nor short vega in warrants for my case?

 

That's right, you cannot sell/write warrants like you can options, but that's irrelevant with respect to my point.

 

16% implied vola is cheap, but 20% bid ask spread is very expensive.

 

but it goes both ways (regarding the 20% bid ask spread)

If I get the direction right, my percentual gains on the capital risked will also be higher.

Should I go for warrants which are more ITM and with a higher delta then?

Those have tighter bid ask spreads.

 

The spreads between bid and ask are costs and go always against you. Don't accept more than 3-4% at warrants as long as you didn't have years of successful experience. A Newbie should start with warrants ITM or at least ATM.

And have a look at the BAR chart! Could still be a bull trap.