Thursday, 10 September 2015

Warrants versus Stocks

If you are optimistic about a stock, the most direct investment strategy is to buy the stock.

However, some investors may choose to buy a related warrant instead.

Pros:  Limited investment amount.

The biggest advantage of warrants is the leverage effect, which allows you to invest with less capital for the same return, as compared with stock trading.

The lower capital required for warrants means that, in case there is a market downturn, the loss will be limited as compared with investing directly in the stock.

In fact, in a number of major setbacks in the past, even giant blue chips fell sharply.  Buying warrants instead of stocks can help minimize one's exposure to such market risks.

Cons:  Time constraint

Of course, warrants are not without their shortcomings.

It takes a lot of time to understand the factors that may affect warrant prices before one can master the leverage effect to one's advantage.

Investors must get to know that warrants are subject to the time constraint.

The price of a warrant may change along with the implied volatility and dividend payout of its underlying and interest rates.

Even if you get the underlying direction right, you may still fail to reap the expected return.  

In case you get it wrong, you should stop the loss.

Never sit on your holdings like a stock investor does to wait for a rebound.  The price of a warrant will be dragged down by not only a falling underlying price, but also a declining time value.

Additional notes:

Warrants are derivatives.
They are an alternative investment to their underlying, and vice versa.
Warrants can never be an absolute substitute for their underlying.
Do manage your portfolio flexibly by investing in warrants and/or their underlying in light of the market conditions and outlook, as well as your own risk tolerance.
If one gets the market wrong, one will lose more from warrants (actual loss over investment cost) than from stocks.
That means the leverage effect of warrants is a double-edged sword.  (Investors must take caution.)
The investment cost for warrants is lower than that for stocks, but they are more volatile.
Hence, their rate of potential gain or loss is much higher than their underlying.

Warrants are a leveraged investment tool.
Don't foreget that the leverage effect can mean more profit, but also more loss.
So do limit your investment amount in warrants.

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