Turnover surpasses levels reached in Switzerland as bearish conditions drive up speculative interest in puts Hong Kong has surpassed markets in Europe to become the most active venue worldwide for the trade of warrants, helped by surging interest from retail investors. For the first five months of the year, turnover in warrants in Hong Kong was about seven billion euros (HK$62.8 billion). This compares with about five billion euros in turnover for Switzerland, the most active market last year. The move to the No1 spot comes amid increasing turnover in put warrants resulting from the bearish market in Hong Kong this year. Cheril Lee, senior vice-president of equity derivatives and structured products at SG Securities (HK), said: 'The Hong Kong market is more mature and efficient, with both the call and put warrants widely and equally traded, unlike Switzerland and Italy where puts are not commonly traded.' Call warrants give holders the right to buy the underlying security at a pre-set or strike level, allowing investors to enjoy geared profits when the underlying security rises. Put warrants give holders the right to sell the security at a pre-set price. These warrants increase in value as the underlying security falls. In the first six months of the year, puts - a bearish bet on the market - accounted for 56 per cent of Hang Seng Index warrant turnover. The trading surge had largely been driven by retail investor interest in covered warrants, also called derivative warrants, which are issued by an investment bank instead of the company of the underlying security, Ms Lee said. In the past, she said, retail investors looking for speculative gains would turn to volatile small caps. 'But now they realise the [potential for] leveraged profits from trading warrants, with blue chips and the Hang Seng Index as the underlying,' she said. Also helping the warrant trade are recent changes to listing and trading rules, which have resulted in more warrant issuers and warrant issues in the market. In 2001, Hong Kong Exchanges and Clearing issued new requirements and amendments to facilitate liquidity and transparency in the warrants market. Under the new rules, issuers of covered warrants must provide liquidity for warrants they list. In addition, a requirement that issuers place at least 85 per cent of a warrant issue to a specified minimum number of investors was scrapped. After the changes, the number of warrant issuers increased from about seven or eight in 2001 to 17 last year. The number of standard warrants traded also jumped, from 381 in 2001 to 666 last year. For the first six months of the year, 558 standard warrants were traded in the market. With the number of issuers and warrants increasing, issuers have been diversifying into products called 'exotic' warrants. Exotic warrants are instruments which carry particular features different from plain vanilla calls or puts. Some exotic warrants - called capped warrants - are structured to cap potential profits. Others will lock in profits if the warrants are in the money on regular fixing dates. Other types of exotic warrants pay a dividend or fixed amount of cash or nothing at all, depending on whether the warrant is in the money at expiry. In the first half, there were 62 exotic warrants traded on the market, compared with 24 for all of last year. Though retail investors may be familiar with stock investing, picking and evaluating a warrant is a different game altogether. A favourite tool among analysts to evaluate a stock is the price-to-earnings ratio. For warrants a similar gauge exists called implied volatility. It measures the volatility of the underlying asset spot price in the market price of the warrant. 'Of the warrants on the same underlying asset, the higher the implied volatility is, the more expensive the warrant is,' Ms Lee said. While covered warrants are growing in popularity among retail investors, institutional investors do not seem keen on using the instruments as a hedging tool. Theoretically, institutional investors could hedge their long stock positions by buying put warrants. But some fund managers said they preferred stock options and futures to covered warrants. 'The pricing of a covered warrant is set by the issuer only,' said Steven Leung Wai-yuen, a director at UOB-Kay Hian Hong Kong. 'The issuer only follows the trend movement to set the price ... this does not truly reflect the fair future value of the underlying asset.' In addition, options and futures provide more flexibility for professional hedgers as the instruments can be sold short. Warrants, on the other hand, do not allow holders to sell their rights to buy or sell as granted in the warrant.