| Naga Wisdom 2 |
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Why Trade Warrants ?
Gearing
Gearing is one of the main reasons for trading warrants. Warrants need a small capital outlay yet offer a higher percentage return (positive and negative) when compared with the underlying asset.
To understand the effect of gearing, please look at the calculations below: shares vs. warrants. Both give you exposure to the price movement of the underlying asset. For warrants however, you only pay a fraction of the underlying asset price for the same exposure.
Example
Scenario 1 - Positive Return |
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Investor A |
Investor B |
| Underlying |
ABC share |
ABC call warrant |
| Buy |
1000 shares |
1000 warrants |
| Exercise ratio |
- |
5 warrants: 1 share |
| Buying Price |
RM2.11 |
RM0.075 |
| Investment outlay |
RM2,110.00 |
RM75.005 |
| Selling Price |
RM2.50 |
RM0.11 |
| Gain |
RM390.00 |
RM35.00 |
| Return on Investment |
18.5% |
46.7% |
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In Scenario 1, ABC's share is trading at RM2.11 and ABC's call warrant is trading at RM0.075. When the share rises to RM2.50, the warrant is already trading at RM0.11, and selling the warrant could gives you a return of 46.7% compared with 18.5% return from the shares. |
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| Scenario 2 - Negative Return |
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Investor A |
Investor B |
| Underlying |
ABC share |
ABC warrant |
| Buy |
1000 shares |
1000 warrants |
| Exercise ratio |
- |
5 warrants: 1 share |
| Buying Price |
RM2.11 |
RM0.075 |
| Investment outlay |
RM2,110 |
RM75 |
| Selling Price |
RM1.80 |
RM0.03 |
| Loss |
-RM310 |
-RM45 |
| Return on Investment |
-14.7% |
-60% |
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A decrease in the value of the underlying asset price will also result in a greater percentage decrease in the warrant price as illustrated in Scenario 2. When ABC's share is trading at RM2.11, the warrant is trading at RM0.075. If ABC's share falls to RM1.80, the corresponding theoretical ABC call warrant price could fall to RM0.03. Total loss to Investor B is 60% whereas Investor A only suffers a loss of 14.7%. |
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NAGA GOLDEN ADVICE
Be mindful that gearing (or leverage) is a double-edged sword. It can amplify your gain but may similarly work against you if the underlying asset moves in the opposite direction from what have anticipated.
Cash Extraction
Cash extraction is a strategy used to release cash tied up in the underlying asset to purchase the warrants of that underlying asset.
Due to the gearing effect of warrants, you only need to use a relatively small amount of cash to purchase a corresponding number of warrants which replicate the exposure you wanted on the underlying asset.
For example, let's say you receive share sale proceeds of RM2,110 (RM2.11 x 1,000 shares). In order to maintain the existing exposure to the share, how many warrants would you need to buy? To buy a warrant with effective gearing of 10 times and an exercise ratio of 5 warrants to 1 share, you would need 500 warrants (1,000 shares / 10 times * 5 warrants) and pay RM37.50 (RM0.075 x 500 warrants). As such, there is a cash extraction of RM2,072.50 (RM2,110 - RM37.50) that can be invested elsewhere.
Diversification
Warrants offer you exposure to local and foreign underlying assets plus different asset classes, e.g. shares, indices, currencies, commodities and baskets (of shares, indices, etc). Therefore, trading warrants may enable you to hold a diversified portfolio without the need to have a huge capital outlay.
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Strategies