The UK traded warrants market, launched last year in a blaze of publicity, may go down as one of the most spectacular failures ever visited on the UK financial markets. Only 660 trades were recorded in the first three months, less than the average daily trade in South African warrants.
The South African warrants market, too, has seen better times. Monthly trade in warrants peaked at R1.6billion in September 2001, but by early 2003 had fallen to less than one-fifth this level, prompting several issuers to abandon this market.
According to the Financial Times, the failure of the UK warrants market is in large part due to the success of financial spread trading otherwise known as Contracts for Difference (CFD) trading.
CFDs exploded onto UK financial markets in recent years and are now the instruments of choice for hedge fund managers. It is reckoned that over 20% of the trade in the FTSE 100 is now linked to CFDs.
Warrants are just too complex for most traders, which is why we are seeing a swing towards CFDs in SA. The UK warrants market is struggling because CFDs have already occupied the market warrants were trying to capture. CFDs sucked the oxygen out of UK warrants because they are cheaper and more efficient trading instruments, and are superior products for speculating.
Warrants are just too complex for most traders, which is why we are seeing a swing towards CFDs in SA.
David Butler, chairman, Global 247
CFDs offer several advantages over warrants: no brokerage fees or Marketable Securities Tax, no time decay, the ability to trade a variety of underlying instruments from commodities to shares and currencies, and direct online trading capability with real-time charts.
Perhaps the primary attraction of CFDs is gearing - and the resulting potential to earn large profits on small movements in the underlying share, bond, index, commodity or currency. CFD gearing levels range from about six times the amount invested with individual shares to 50 times on bonds and currencies. A CFD trader will only have to place margin of R150 (or 15%) to gain exposure to R1000-worth of Sasol shares, for example. The CFD will match every R1 price movement in Sasol`s share price, which translates into just over six times gearing ratio because of the smaller capital requirement. Warrants will not match price movements in the underlying security in the same way due to time decay and constantly fluctuating gearing and volatility levels.
The CFD trader never takes ownership of the underlying security. All he is purchasing is the price movement in the underlying security. Exposure to price movement is the reason most people invest in shares or warrants in the first place, but CFDs allow them to do this far more efficiently.
Another big attraction of CFDs is the ability for traders to make profits whether markets are rising or falling. Traders are able to "go long" (buy in anticipation of a price rise) or "go short" (sell in anticipation of a price drop) with equal ease. The same is not true of warrants. A warrant trader seeking to profit from a price drop must purchase a "put warrant", which typically offer muted gearing levels.
Several variables make up the price of a warrant, the most important of which - volatility - is prone to manipulation by issuers and cannot be tracked by traders as it is not quoted live on any market in the world. Warrant traders often feel cheated out of their profits when the warrant price fails to respond as expected to movements in the underlying share price. This is usually because the issuer tampers with the warrant`s volatility mid-stream.
No such tampering is possible with CFDs, which offer generally better levels of gearing. This explains why, at a time of collapsing world markets, CFDs continue to flourish. And while warrant issuers are feeling the pinch, spread trading companies continue to grow strongly through good markets and bad.
Another important difference between warrants and CFDs: with warrants, the downside is limited to the amount invested, while CFD traders must establish a stop-loss to achieve the same protection.
Many traders have switched out of warrants because they recognised that CFDs are more efficient and less costly trading instrument, and it is expected that SA will soon emulate the UK market, where CFDs are rapidly dominating trading in the FTSE 100 companies.
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