Structured warrants cost a fraction of the price of their underlying security and allow investors to gain exposure to this underlying security without actually owning it. The fact that you can trade structured warrants with a considerably smaller investment outlay gives rise to a variety of warrant strategies.

Leverage

One of the most attractive features of structured warrants is the leverage effect that they can offer. Once the investor has established a strong view on the movement of the underlying security, he/she can buy a structured warrant, which costs a fraction of the price of the underlying security. As such, structured warrants present the advantage of limiting the losses to the price paid while offering unlimited directional exposure to the underlying security. (However, investors should remember that the potential pay-off of put warrants is limited due to the fact that the value of the underlying security cannot fall below zero.)

Example: both Susan and Ken think that stock XYZ has some upside potential. While Susan chooses to long 1,000 shares, Ken would like to invest in 10,000 call warrants on XYZ that provide an effective gearing of around 6 times.

On day 1, stock XYZ is trading at SGD16 and the call warrant is trading at SGD0.20. Let's suppose that one week later, stock XYZ trades up 12.5% from SGD16 to SGD18. Following the rise in the underlying security, the price of the call warrant rises from SGD0.20 to SGD0.35.

In the above example, the buy calls strategy outperforms the buy shares strategy in terms of percentage gain due to the leverage involved in structured warrants. (The example has not taken into account of change in implied volatility, time value and other pricing parameters. The pricing parameters will be discussed in Part 3.)

One might ask that in terms of dollar gain, the buy shares strategy still looks more attractive. But look at the initial capital outlay as well! The buy shares strategy requires a capital outlay of SGD16,000 which is way above the capital outlay of SGD 2,000 required by the buy calls strategy. As a matter of fact, aggressive investors can consider buying more call warrants to attain a higher leverage. For example, instead of buying 10,000 calls, one can consider buying 15,000 calls so as to achieve a potential gain of SGD2,250 (similar to the dollar gain of the buy shares strategy) while maintaining a capital outlay of SGD3,000 only.

Cash Extraction

Another interesting strategy involving structured warrants is cash extraction. By replacing the shares in the portfolio with structured warrants, investors are able to extract cash while maintaining an equivalent level of exposure to the underlying securities.

Example: Samantha wants to keep her exposure to stock ABC but is in need of cash. She decides to extract cash through replacing the ABC shares in her portfolio with call warrants with a delta of 0.05 per warrant.

On day 1, Samantha sells 2,000 shares of ABC at SGD21 and buys 40,000 call warrants (2,000 shares divided by the delta) at SGD0.175. Let's suppose that two weeks later, stock ABC continues to rally and trades up to SGD25. Following the rise in the underlying security, warrant price rises to SGD0.375.

By replacing the shares with call warrants, Samantha successfully extracts SGD35,000 "locked-up" in the portfolio (SGD42,000 - SGD 7,000). The cash extraction strategy also enables her to limit her downside risk while keeping full upside exposure. Notice that the number of warrants to be bought is calculated by dividing the number of shares by the delta per warrant, so as to achieve a potential dollar gain from warrants that is similar to that from holding shares.

(The example has not taken into account of change in implied volatility, time value and other pricing parameters.)

Hedging

So far we have been talking about call warrants. What about puts? A popular strategy involving put warrants is the hedging of a portfolio, i.e. protecting the portfolio's value against a market correction.

Put warrants can act as an insurance policy as they guarantee a minimum value for the underlying security (which is equal to the strike). The price of the protection is the warrant price paid. Should the market fall, the value of the portfolio will decrease. However, this loss can be partially or fully offset by the appreciation of the put warrants.

Example: Michael believes the market is going to drop in the near term. He has a stock portfolio worth SGD60,000 that he would like to hedge using put warrants. Let's suppose that Michael invests SGD5,400 to buy 20,000 put warrants on the stock that provide an effective gearing of around 7 times. This means that Michael pays a premium of SGD5,400 to partially insure for a stock portfolio of SGD 60,000.

Two weeks later, the market goes down as expected and the value of Michael's stock portfolio is down by 8%, registering a loss of SGD4,800. On the other hand, the price of the put warrant rises by around 56%, from SGD 0.27 to SGD0.42. The gain from the put warrants, SGD3,000 in this example, helps partially offset the loss of the stock portfolio.

(The example has not taken into account of change in implied volatility, time value and other pricing parameters.)