Worried about a Market Correction? Try Warrants

Worried about a Market Correction? Try Warrants

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The 40- and 200-day moving averages of the JSE’s Top 40 index suggest that the index could soon fall by about 15%.
For investors, that means it’s best to stay on the sidelines – or there are products you can invest in to make money in both a bull and bear market. One of those tools is the warrant.

According to the JSE’s website, warrants are speculative financial instruments listed and traded as listed options on the JSE, whose value depends mainly on the underlying shares or indices over which they are listed. They give investors the option to buy (in the case of ‘call’ warrants) or sell (in the case of ‘put’ warrants) an underlying asset, at an agreed price (called the strike price), on or before an agreed date (called the expiry date). They are usually listed for six to eight months, then they expire.

As shares or indices rise or fall, prices of call warrants will follow the shares while put warrants will have an inverse relationship to the performance of the share prices. In other words, if you are bearish you buy a put. Warrants are geared anything from two to ten times, thereby offering speculative traders greater potential return than ordinary shares. At 3 – 6 times gearing, if a share over which a put warrant is listed drops 5%, one could make 15%-30% in the warrant. On the flip side, if the share rises 5%, you could lose that 15%-30%. That is why understanding the product and adhering to your stop loss is so vital. If you bought a warrant at 30c, the most you could lose is that 30c, even if the share over which it was listed fell from R100 to zero. In contrast, when trading single stock futures or contracts for difference, traders can lose far more than they initially invested in the instrument.

Some important rules

As to who should use this product, only those investors wanting to gain geared exposure to the price movements of underlying assets; those investors prepared to lose their entire initial investment; or those investors wanting to protect existing portfolios against adverse price movements. If you fall into one of those categories, here are some tips to reduce the risk:

  • Only trade warrants with more than three months to expiry date.
  • Only trade warrants between two to six times effective gearing (EG), as more than that is beyond what most people can stomach. A warrant with an EG of five times will move 5% for every 1% the underlying share moves.
  • Invest at most a fifth of your total portfolio in geared instruments such as warrants, keeping the bulk of the portfolio in longer term instruments such as shares.
  • Set up a separate warrants trading account. The short-term nature of warrants trading means that SARS is likely to tax profits on warrant trades as income.
  • Trade with a strict stop loss, as these help take emotion out of exit strategy. Also, set exit points (profit-taking levels), and adhere to them.

Benefits

Warrants are easy to find: each of the major banks act as market makers in warrants. Each also has an online trading platform, often with comprehensive tutorials.

Warrants are very liquid securities, and therefore easy to get in and out of. Furthermore, they are less expensive to invest in compared to the underlying assets. Perhaps the biggest advantage of all is that the most an investor can lose from investing in a warrant is the initial price paid for the warrant, as opposed to the full price of the stock. Warrants give investors exposure to a wide variety of asset classes, including equities, indices or bonds.

Eamonn Ryan
Before becoming a financial writer and freelance journalist in 1997, Eamonn Ryan was a legal adviser, company secretary and alternate director at listed company Cashbuild Limited from 1988 to 1997. Since becoming a financial writer, he has focused on the business and financial sectors, as well as personal finance, writing for Finweek, The Star Business Report, Sunday Times Business Times, Business Day, Mail & Guardian, Entrepreneur, Corporate Research Foundation (which brings out a series of books each year ranking SA’s best employers and best managers), as well as a host of once-off and annual publications such as ‘Enterprising Women’ and ‘Portfolio of Black Business’. He also writes media releases, inhouse magazines and sustainability or annual financial reports for various South African corporates and financial services groups, including the Ernst & Young annual M&A book.