Thursday, August 12, 2010

Callable Bull and Bear Certificates – an evolution of exotic options

This article appeared in Capital page of The Edge Malaysia, Aug 1-7, 2010

Malaysians are fortunate to be the first retail investors in South East Asia to trade the exotic Callable Bull Certificates (CBLC) and Callable Bear Certificates (CBBC), launched by CIMB earlier this month. Some investors must be curious about this product as to how it is an option similar to structured warrants in Malaysia, but yet differ significantly in other aspects.

In this three-part series, I will show how CBLCs and CBBCs are linked to exotic options, describe their essential features as well as provide examples of the product dynamics, pricing and risk. The focus however will be the motivation for the investor trading this product and what he should be aware of.

Similar products to the CBLC and CBBC are being traded around the world, but with different labels. It first appeared in Germany in 2001 as “turbo warrants”. In Australia they are known as “knock-out warrants”, in Hong Kong as “callable bull and bear contracts” and in some countries as “stop loss warrants”. In this article, for simplicity, I will refer to both the callable bull and bear certificates as “CBBCs”.

CBBC - an evolution of barrier options

CBBCs are actually a product of a barrier option, a kind of exotic option. I will briefly illustrate this below:

 A recollection – what is an option

A previous article on structured warrants (“Structured Warrants – knowing the product”, Nov 16-22, 2009) explained how standard options work. To recollect, when the investor buys a call option on a stock (share), he pays a fraction of the stock price by paying a premium, and has the right to buy the share at a predetermined exercise price within a certain time period. If the underlying stock exceeds the strike price, the option price (premium) usually rises and the investor often chooses to close the contract and make a profit. If the stock does not reach that strike price during its tenor, the option expires worthless and the investor only loses his premium. Structured warrants share these same characteristics.

 ...and now a barrier option

In the standard option, payoff depends on whether the underlying stock price hits the exercise price (or strike price). Let us say the underlying stock price (S0) is $4.00 and the strike (X) is $3.50. This call is then, already in-the-money.

Now, in a barrier option, an additional level is placed. Say this level (H) is at $4.30. If the underlying stock of $4.00 reaches level H of $4.30 within the stipulated tenor, two things may occur:

I. The option will cease immediately, or is knocked out, or called. The payoff to the investor when this happens is simply the barrier level minus the strike price (H-X or $4.30 - $3.50). Note that in a standard option, the payoff to the investor would be Sn – X; Sn being the future price of the underlying stock which could be above or below its current price, $4.00. It is obvious here that with a barrier in place, the investor is limiting his upside as he seems satisfied when Sn reaches a particular level (in this case when Sn reaches H of $4.30). Intuitively we would expect the premium of the barrier then to be cheaper than a standard option. This is one of the key motivations for the investor to trade barrier options.

II. The option will start its life- or the option “knocks in”. Here the option only starts when the stock price reaches $4.30. When this happens, S0 will now be $4.30 and X is still $3.50. It will then behave like a standard option.

The barrier, H can be set above the stock price as in the above example or below the stock price. When the barrier is set above S0 , the investor is bullish about the stock. We then have either an “Up & Out” or an “Up & In” option. When the barrier is set below S0 , the investor is bearish about the stock and we have a “Down & Out” or a “Down & In” option. These properties are illustrated in Chart 1.

Chart 1 – The Standard Option vs. Barrier Options

The main motivation for using barrier options is that it involves less upfront cost (premium) and it does not require vigilant monitoring by the investor to match his personal stop loss criteria. This of course comes at a price -the payoff the investor gets with a barrier is limited (to H) compared to the standard option where his upside is unlimited. Note that in both barriers and standard options, the downside is limited to the premium paid upfront.

 CBBCs – a case of a Knock Out Barrier Options

CBBCs are actually specific knock out barrier options, designed for the retail investors. In many markets, only in-the-money types of CBBC options are traded. A standard knock out call option for example, when purchased, may be in any of the following three states:

I. At the money – here the barrier is set to equal the strike price, X. (H=X). In these kind of options, when the stock price hits H, the option will cease and the payoff will be nil (as H-X =0).

II. In the money – here the barriers is set above the strike price, so that when the barrier is hit, there is a payoff to the investor of H-X.

III. Out- of –money – in this kind of barrier option, the barrier is set below X. When the barrier is hit, the call option will expire worthless. The investor’s motivation here is to profit on the value of the barrier option itself by selling it off before expiry.

When turbo warrants first appeared in Germany in late 2001, they were nothing other than standard knock-out barrier options. However, a more interesting environment emerged when the barrier was set to be strictly in the money so that a payoff (often called rebate or residual value) is made if the barrier is hit. Buying and selling turbo warrants in Germany then constituted 50% of all speculative derivatives trading. According to Bursa, CBBCs in Malaysia will be “at-the-money” and “in-the-money” type options, referred to as Type I and II CBBCs respectively. The “Up & Out” and “Down & Out” barrier options shown in Chart 1 are examples of in-the-money type barrier options, relevant for CBBCs.

During a risk management seminar in Europe in March 2007 (source: The Standard, Hong Kong, 30/4/2007), Professor Maraco drew an analogy, applicable to CBBCs. "Knock-out is like your girlfriend. When you date her, you anticipate a happy ending, like the market price going in your anticipated direction until expiry. But you should remember that she may break up with you one day, just like the knock-out level being reached, and you may have nothing left. However, your loss is limited to what you have invested - you will lose nothing more after the knock-out!"

What Next

CBBCs seem to be a very appealing derivative instrument to trade, moreover given their success in other countries. But over-zealous investing could lead to unexpected losses, one of the cases being BJCORP-JA that was called just after 5 days of trading in Malaysia. In fact, I agree with Alan Voon in that “with very limited introduction of the products to the investing public and lack of up-to-date data and calculators in the issuer’s website, it is rather strange to see these CBLCs being so heavily traded”.

It is imperative to understand these products and not treat them like normal warrants. In the next article we will discuss the essential features of CBBCs and examine some examples on how they work.

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