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Thinking of trading warrants?

Start by figuring out how market makers hedge themselves and make money

A few weeks ago I wrote a story about a group of professional traders who filed a complaint with the SGX and MAS about the market making of Macquarie Warrants or MW, specifically for the latter's Hang Seng Index warrants. The accusation was that when the underlying index moved in a particular direction, the associated warrants didn't react correctly. So when the HSI rose, the calls fell and when the HSI fell, the puts also fell. After investigating, SGX concluded that MW had acted within the parameters as set out in its term sheets, so there was no case to answer. Similarly, MW conducted an internal check and reached the same conclusion. The episode is interesting because it illustrates to me that even professionals sometimes need to be reminded how the warrants business and market making works.

The first thing to note is that MW has been providing market making for structured warrants here for about 8 years now. Deutsche Bank was the first mover in the segment around 10 years ago, one that was quickly invaded by the likes of UBS, Soc Gen, BNP and MW. Initially the segment proved lucrative but over the years interest appears to have died off, with the result that MW is now the main player with an estimated 90% market share. And, as MW would correctly point out, they cannot have lasted this long if they systematically rig prices such that the trading public loses money. This is an important point to bear in mind - in a reasonably competitive and sophisticated market, you cannot consistently fool people because they will simply walk away.

The second thing to note is that although most of the market making is computerised, human intervention is still needed. MW isn't in it for its health, like all issuers it is in it to make money. So anyone who wants to trade structured warrants must familiarise themselves with how this is accomplished. For example, when the underlying market moves up, issuers like MW have to hedge themselves as quickly as possible otherwise they could lose their pants. If the underlying rises, they might buy it,  or look to buy or sell other similar instruments like traded options. This could take time, so in times of extreme volatility, the hedging could result in slower market making. Or to put it differently, when there are very large spikes in the underlying market in a short span of time, it would not be realistic to expect prices to react instantaneously. Instead, a short delay should be expected and I think this is what happened in the instances that formed the complaint. Of course if the volatility persists over an extended period, issuers could lose so much money that exiting the market could be the only option. I think this is what occured for many of the issuers who used to be active here 7-10 years ago but have since departed.  

So if you are thinking of trying your hand in the warrants market, apart from studying pricing models and the role that time and volatility plays, it would be a good learning exercise to figure out how market makers make money, how they hedge themselves and of course, how they set prices.