Warrants For Trading In Volatile Markets

By Rabobank International

Structured warrants are versatile trading or investing instruments that can offer a wide range of benefits to investors in helping them enhance their investment portfolios. Investors can implement investment strategies according to different market conditions – whether up or down – in order to gain leveraged exposures to market movements, or manage portfolios risks.

Warrant basics
Warrants are derivative investment products in that they derive their value from underlying assets such as stocks or market indices. It gives the investor the right to buy or sell the underlying asset at a certain exercise or strike price within a certain time frame.

Warrant investors however do not need to hold a warrant to maturity. They can trade them like shares, but at a fraction of the cost. They do however have to note the expiry date, which is often 3 to 6 months from the date of issue.

The biggest advantage of warrants over stocks trading is the gearing or leverage effect. For example, if you buy a warrant with ten times gearing on a stock, worth say $20 per share or $20,000 for a trading lot. If the share price gains 1%, you

make a profit of $200. With a warrant, you make the same return with an outlay of only $2,000.

There are two types of warrants: Call and Put. A call warrant gives investors the right to buy the underlying asset from the issuer at a specified price on a particular date. An investor who purchases a call warrant usually believes that the value of the underlying asset will rise during the lifetime of the warrant. Conversely, a put warrant gives investors the right to sell the underlying asset to the issuer at a specified price on a particular date. Investors with a ‘bullish’ view of the market would usually buy a call warrant, while investors with a ‘bearish’ view of the market would buy a put warrant.

If we look at the historical volatility chart (figure 1), you will notice that volatility levels for the Index of FSSTI have picked up sharply in the last few months. The STI index 100 days historical volatility is currently at about 28.5%, which means a daily movement of roughly 1.8% – more volatile then anytime over the past five years. This is due in part to several factors including:

• The breakout of the subprime mortgage and credit crunch

• The effects of foreign funds flowing into the Asia region

• The rise of commodity prices and its related equity; and

• The higher frequency of changes of fund rates by the U.S. Fed.

Source: Bloomberg

Warrants trading under current conditions

A lot of retail traders are currently taking a very short-term view on underlying assets, often putting on large positions and taking profit of a few spreads if the warrant moves in their favour. This strategy works at times, but the traders are actually taking more risk in this volatile market environment. 

Let’s take an illustrative example where a warrant is priced at S$0.517 when the Straits Times Index (STI) is at 3,016. When there is a 2% correction in STI, which is seen quite often in intraday market trading lately, the price of its corresponding warrant will drop to S$0.458, a decrease over 11%.

A lot of traders might not have realised that as volatility increases, the risk they are exposed also rises. In other words, their capital exposure risks have risen for the same return they are seeking.

Put warrants provide investors with an investment vehicle that can profit from a falling market. But they can also protect a portfolio when the market trends downwards, in that any falls in value of the stock you are holding would be offset by gains in the price of the put warrants. This is known as hedging. In short, it can be perfect instrument for balancing your share portfolio risks.

When implementing the hedging strategy, investors will need to first pick a warrant. They should consider the time frame they would like to insure the portfolio for, as well as their own appetite for risk. Put warrants with a higher exercise price are generally more expensive, but the protection starts earlier.

The benefit of hedging is that it will protect investors from downside risks. This is because it allows investors to lock in gains while still retaining the exposure to the stock market. However, investors need to note that if the market rises, the warrants will be worthless when they expire. This reduces the upside of the portfolio by the cost of the warrant.

Hedging share exposure with Call warrants

Hedging also works for call warrants when investors are uncertain about buying shares or do not have enough funds. Call warrants can act as a hedging tool, allowing them to lock in a purchase price today.  By purchasing call warrants instead of investing directly in the underlying shares, investors are still able to have exposure to the upside in the share price, while limiting their downside risk if the share price underperforms. 

By using this strategy, investors can lock in exposure to the shares without committing all the funds upfront. The cash can be then be channelled into other investment assets such as earning interest in a cash management account. This could help offset some of the cost of this strategy. 

Investment tips

A note of caution though. Since warrants provides higher returns, the risks are also higher. Generally, you should not invest more than 10% of your investment capital in warrants. Retirees with low risk tolerance should not use warrants as an investment to maintain their lifestyle. Investors should also be more disciplined and know when to take profits and more importantly, when to cut losses.

This article seeks to offer some strategies for a reader’s consideration and reference. It is for educational purposes only.