Why invest in warrants?
A hedging tool
As with any instrument, money can be made and lost when trading warrants.
Mr. X, 37, would know. Three weeks ago, he lost about $25,000 in just two weeks after trading in some Straits Times Index warrants. 'Greed made me lose a lot. I was hoping my initial losses could be recovered, but this didn't happen,' he said.
Investors should also be disciplined about taking profits and cutting losses. Investors are advised to monitor their positions closely as warrants tend to move in greater percentage terms than shares.
Mr. P, 32, started trading warrants this year with a principal sum of $15,000. He made a 25 per cent return in just three days, after he bought DBS Group Holdings and CapitaLand warrants in September. But he lost about $20,000 in two weeks when the stock market nosedived recently. 'I wasn't careful, so I didn't cut my losses fast enough,' he said.
You also need to factor in the timeframe - and be confident that the underlying asset price is set to reach your price target at the same time that the warrant matures.
'If you believe the market is going to have a sharp correction soon, you should choose a short-term out-of-the- money put warrant.'
'If you expect a stock to move up gradually in one to two months' time, you should choose a mid-term at-the- money or a 1 to 5 per cent out-of-the- money call warrant.'
What are the five variables and how do they affect an option's value or premium?
Options values or premiums on puts and calls are function of five variables. The five variables are:
1. the underlying asset value,
2. the risk-free rate,
3. the standard deviation of the return of the asset,
4. the option's time to maturity, and
5. the option's exercise price.
A call option's value will increase with increases in the underlying asset value, risk-free rate, time to maturity, and standard deviation of returns. However, a call's premium will decrease as the striking price increases.
A put's value will increase with increases in the exercise price, the time to maturity and standard deviation of returns, and decrease with increases in the underlying asset value and risk-free rate.
If dividends are considered, a call's value will decrease with dividends while a put's value will increase.