Bull, Bear Contracts Take On Each Other Callable bull/bear contracts (CBBC), which are newly developed derivatives, fit very much the appetite of investors recently. They become among favorite picks of investors as they have leveraging effects and the call level enable holders to end loss. With their supplementary nature, no wonder bull and bear contracts rise to prominence as investment tools favored by investors.

In recent months, local financial market has been being volatile and without specific direction. Local stocks traded down and market turnover contracted to less than HK$40 bln, reflecting steam is running out to spur the market. Nonetheless, CBBC, which emerged in the local market since 12 June 2006, became investors’ favorites and accounted for nearly 20% of market volume with a maximum turnover of over HK$13 bln.

Johnny Yu, Managing Director at UBS, expressed that the number of CBBC issuers climbed from three to nineteen at present, revealing the fact they are popular investment tools, especially during a time the market is volatile and without direction, when the implied volatility of warrants would be huge. CBBC only need holders to identify whether the indices will go up or down, taking the local market by storm with the possible immense gains incurred by merely putting in a small amount of principal. Germany, Britain, Australia and Malaysia developed CBBC market earlier than Hong Kong, Yu said, but the CBBC transaction volume in the latter first exceeded the warrants market in 2009, disclosing there is great potential to develop CBBC market here. In general, strike price of bull contracts is lower than the call level while strike price of bear contracts is higher than the call level.

From the perspective of product nature, there are two major differences between warrants and CBBS. Wong Man Huen, the vice president of equity derivatives division at JP Morgan, indicated that, firstly CBBC belongs to investment products with far below/above moneyness and Delta being close or equivalen to 1. CBBC are not affected by implied volatility and their price trend more closely follows indices and stocks. Second, when the relevant stocks o indices of CBBC reach the call level, the CBBC would be called, in a way helping investors to cu loss. She emphasized the operation of CBBC has similarities with that of futures and both charges investors financial expenses. According to the calculation formula of financial expenses, such expenses of CBBC are equal to -1 times (time to maturity/365 days), being one of the factors determining the price of CBBC.

The other decisive factor of CBBC price is the intrinsic value. The intrinsic value of bull contracts is equal to (spot asset price – strike price)/ entitlement ratio. Some aggressive investors focus on seeking those CBBC with spot price close to call level in order to obtain higher gearing ratio yet the relevant risks are also higher. For CBBC with the same strike price and same maturity period, the face value or value would be lower if the entitlement ratio is higher. Yet, such values would be relatively less sensitive to stocks and indices.

Wong advised aggressive investors to choose CBBC with lower entitlement ratio, like 8000:1,besides picking those with spot price close to strike price. She elaborated the implied meaning of 8000:1. Theoretically, CBBC would move by one pip only for every 8 pts movements of futures, she said. For 15000:1, CBBC would move one pip for every 15 pts movements of futures. In other words, the former’s sensitivity is higher than the latter. If there is large market volatility within a single day, investors are suggested picking CBBC with higher entitlement ratio. On the contrary, if the market moved in a range- bound situation, investors are recommended to choose those with lower entitlement ratio.