Debate resurfaces over volatility of warrants
Some brokers say heavy trading in the paper and hedging activities accelerate the stock sell-off
The 301-point drop on the Hong Kong stock market yesterday may revive the old debate over the inherent volatility of warrants and their alleged ability to transform an orderly retreat into a chaotic rout.
While no observers blamed warrant punters outright for yesterday's retreat, several brokers said that warrant trading had 'exaggerated' and 'accelerated' the sell-off.
Issuers typically argue that warrant trading - and the accompanying hedging activities - provides liquidity for the market. Critics say heavy volumes of outstanding warrants become more important than the fundamentals behind the underlying stocks, resulting in irrational trading patterns and prices.
Market participants note that the late afternoon rebounds in the market this week were partly driven by hedging activities related to buying of highly leveraged warrants. Such buying may have postponed the correction of the latest 1,500-point rally which some analysts argued was long overdue.
As the market started falling yesterday, however, warrant issuers needed to offload some of their holdings of underlying stocks to adjust their exposure, accelerating the decline.
Winston Choi, director of retail equity derivatives at BNP Paribas, said big funds started to sell blue chips after BOC (Hong Kong) reported its interim results.
'The slide in leading stocks triggered call warrant investors to sell whatever they had on hand, in turn prompting warrant issuers to sell the underlying stocks or index future contracts for hedging. Eventually, the result was panic selling across the board,' he said.
The most actively traded call warrants on the Hang Seng Index - HSBC Holdings, Hutchison Whampoa, Sun Hung Kai Properties and China Life Insurance - fell between 20 per cent and 30 per cent.
Warrant trading turnover yesterday reached a three-year high of $7.55 billion, 13.7 per cent above the $6.64 billion recorded on Wednesday. However, as total market turnover ballooned to more than $33 billion, warrant trading accounted for only 22.5 per cent of the total, compared with 26.2 per cent the previous day.
The amount of outstanding call warrants, which give the investor the right to buy the underlying stock or index at a fixed price, has been increasing steadily over the past two months. This meant the pool of stocks bought to hedge this issuance would also have been increasing in the days leading up to yesterday's sell-off.
Venus Wong, director at KBC Financial Products, said warrant issuers were not intentionally pulling down the index.
'When investors sell call warrants, it's the issuers' duty to sell the underlying stocks. A further market slump gives rise to more warrant selling, intensifying the sell-off cycle,' she said.
Miss Wong said KBC issued a warning to its investors this week in which it pointed to the unusually high turnover in the warrant market and suggested it might be better for investors to stay on the sidelines.