Warrants with less than three weeks until they mature, and which are more than 10 percent out-of-the-money (OTM) are often called penny warrants.

They are of very high risk nature, and the odds of making money from investing in these warrants are slim. There are many reasons for this and among them are:

1. The bid/ask spreads of penny warrants are wider than normal, as risks arising from hedging these warrants are high. Because of the wide spread, it is both costly to buy or sell the warrant. In addition, a tick in a penny warrant can be huge. For example, if a warrant price edges up a tick from $0.05 to $0.055, it is a 10 percent increase. Hence, the underlying may have to move by a wide margin in order for the price of a penny warrant to change.

2. Penny warrants have a very high rate of time decay. For example, the fall in the value of the warrant arising from the passage of time. Assuming we have two warrants on the same underlying. Warrant A is a shorter-term 10 percent OTM warrant expiring in about 1 month; while Warrant B is a medium-term at-the-money (ATM) warrant.

For Warrant A, the theta per day (the rate of time decay) is around 3 percent. This means that warrant price will decline by about 3 percent of its value each day, even if the underlying stays steady. This type of warrants is greatly affected by time decay, which gradually accelerates. Warrant B is not a penny warrant, and it has a theta per day of just around 0.8 percent. Hence, it faces less pressure from time decay.

From the above examples, one can say that the time decay for penny warrants is very high and investors should be very careful with investing in such warrants.

SG Securities (HK) Limited contributed this article.

(HK Edition 05/19/2008 page2)