Avanidhar Subrahmanyam’s examination of warrant trading reveals individuals’ poor grasp of complex securities
Behavioral finance studies show again and again how individual investors become their own worst enemies by making uninformed or downright irrational decisions. It’s dangerous enough when those poor decisions involve relatively straightforward securities like stocks or bonds. What happens when the investments are more complex?
Nanjing University’s Xindan Li, UCLA Anderson’s Avanidhar Subrahmanyam and Nanjing University’s Xuewei Yang sought to answer that question by studying Chinese investors’ experience with so-called stock warrants, a type of derivative security introduced to Chinese markets in 2005. It turned out to be a lesson in financial mismanagement for many small investors who treated the warrants more like lottery tickets than an investing tool.
In a working paper, the authors detail their analysis of warrant trading by 223,745 investors from January 4, 2007, to October 16, 2009. The data were provided by a major Chinese brokerage without disclosing the investors’ identities, other than to differentiate individual investors from institutions. (The paper follows one by Subrahmanyam and co-authors on insider trading knowledge in Chinese stocks, also based on a large set of brokerage account data.)
Warrants are similar to stock options. A “call” warrant gives an investor the right, but not the obligation, to buy a specific stock at a specific price by a set date. But while options are contracts between investors, warrants are issued by companies themselves. In 2005, the Chinese government authorized the issuance of warrants to public shareholders of companies that were partly state-owned, as a component of the transition away from state ownership. The warrants essentially were compensation to public investors for the effect of state-owned shares’ flooding the market.
The authors’ analysis of warrant trading found that institutional investors overall made money buying or selling the instruments. But individual investors as a whole racked up what the authors gently termed “a material decrease in wealth” as warrant traders ― with losses of about $220 million, including trading fees.
One key to successful trading is to understand the logical per-share market value of a call warrant relative to its “strike” price (the price you’d be required to pay for the stock), its expiration date and the current market price of the stock. What Li, Subrahmanyam and Yang found was that individual investors exhibited a high “skewness” in their trading decisions. That means the outcome was likely to be similar to buying an expensive lottery ticket: Most players would lose 100 percent of their money, while a handful would win big.
That was evident in investors’ focus on “out-of-the-money” warrants, meaning warrants whose strike price was above the market price of the stock. “We find that over 90 percent of investors’ under-performance is due to out-of-the-money expired warrants during the last few trading days of these warrants,” the authors write.
Instead of avoiding these warrants because they were poised to expire worthless, “a considerable number of investors appear to adopt a so-called ’doubling’ strategy, i.e., scaling up positions to recoup past losses,” according to the researchers.
Paying even pennies for a warrant that’s about to expire and is out of the money ― it has, say, an exercise price of $26 per share to get stock that’s trading for $24 ― obviously makes no sense. It seems that some investors assigned intrinsic value to the warrants themselves, rather than see them as having worth only if they’re in the money.
Indeed, on the expiration day, out-of-the-money warrants often saw “frenzied” trading in the securities, as some investors continued to ascribe a value to warrants that were all but certain to be worth zero in a matter of hours, the paper says. The authors deemed it “an extreme version of irrational speculation.” Meanwhile, investors’ lack of understanding was evident in their comments on online bulletin boards, the authors noted, with questions such as “Why is trading [in warrants] suspended?” (because they had expired) and “Will the warrant disappear forever?” (yes).
Who’s to blame for Chinese individual investors’ painful experience with stock warrants? Brokerage clients were supposed to read and sign a government-mandated “warrant risk disclosure letter” before trading, the paper says. But “due to slack supervision, many brokerage firms did not comply with this rule,” it says.
Regulators also were at fault for design flaws in some warrants that made it more difficult for investors to profit. “This underscores the importance of ensuring adequate financial sophistication amongst designers of trading mechanisms for complex securities,” the study says.
Generally, the payoffs on derivatives are tricky to understand. Individual investors should be extremely cautious before trading in these securities, as a complete loss of investment is highly likely, as opposed to trading stocks, where it is unlikely.
If there’s any consolation for individuals, it may be that the study found that plenty of institutional investors committed warrant trading blunders as well. The trading of a savvy few professionals put institutions overall in the black in warrant trading, but “our evidence shows that there are at least as many naive institutional investors as smart ones,” the authors say.