Traditional corporate equity warrants

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15. Investing strategies

Warrants are a great speculative instrument, and therefore it's not surprising that most investors use warrants for exactly this - speculation. But there are other ways to use warrants. This section looks at speculation and at some of those other investing strategies.

Speculation

If you've read the section on analysis in this course, your head may still be spinning a bit from all the different technical indicators that exist to analyse warrants. However, while it is important to understand these indicators it is not necessary to use all of them all the time. For many occasional warrant investors, just one indicator - the CFP - will be sufficient.

And if warrant investing seems complicated, it needn't be so. While being wary of obvious traps, speculating in warrants can be very simple. For example, if you find a warrant with a CFP of 3%, a few years to maturity, and you think there is a strong likelihood the shares will grow at well over 3% annually - easy, buy those warrants! If the shares do grow at a rate of over 3%, you'll leave the share investors in the dust.

Gearing switches

A variation on simple speculating may be termed a gearing switch. This assumes that an investor is already invested in the shares, and forecasts that the share price will grow at a rate greater than the associated warrant's CFP. In this case, the investor can sell the entire holding in the shares and switch into the warrants.

The reason for doing this is to enhance the investment performance by exploiting the warrant gearing. Of course, the switching itself will incur transaction costs that must be taken into account, but the resulting superior performance will usually offset those costs. The increase in hoped for performance can be roughly forecast using the implied gearing. For example, if a warrant has an implied gearing of 4, a gearing switch could deliver a performance approximately 4 times greater than the simple share price increase.

Hedging switches

The above strategy assumes that one switched the whole of an investment from shares to warrants. But, having sold the shares, the resulting cash doesn't all have to invested in warrants.

For example, say a warrant has an implied gearing of 4, and after selling the shares, 25% of the resulting cash is invested in the warrants, and 75% of the cash put on deposit. If the share price subsequently rises, then only 25% of the total investment is exposed to this rise (via the warrant), but that warrant part is geared 4 times. The net result is that the 25% invested in warrants will perform approximately the same as if 100% of the investment was in the shares.

This strategy has some useful features:

• By switching into a combination of warrants and cash, only a portion of the total investment is now exposed to share price fluctuations and therefore at risk. In the example above, 75% of the investment was in a deposit account, and only 25% invested in the warrants - hence the maximum downside for the investment is just 25%
• A further refinement of the above is based on the observation that when prices fall, the premium of warrants tends to rise. Therefore, warrants do not fall quite as much as the implied gearing would forecast. This suggests a strategy of switching out of shares into warrants+cash when premiums are low, and reversing the switch after a marker fall when warrant premiums have risen.
• One of the features of warrants is that they do not pay any income. However, an investment involving warrants and cash on deposit could have a useful yield.

A couple of notes on this strategy:

Like many strategies, a hedging switch is not appropriate for all warrants. Careful watch of the warrant premium must be made.

The ratio of warrants to cash held will depend on the effective gearing of the warrant. There are a number of different ways to estimate the effective gearing. One crude, but effective, method is to use the implied gearing - a calculation we looked at in the analysis section. Another method would involve the application of an option valuation model like Black-Scholes, which is not covered in this course.

Synthetic convertible bonds

In the above strategy (hedging switch) the investor sold his existing share holding and switched into a combination of warrants and cash (which was placed on deposit). A slight alternative to this would be, instead of placing the cash on deposit, to buy bonds with the cash. If the bonds are of a similar maturity to that of the warrants, and the credit rating of the bonds is similar to that of the underlying company, then the investor has effectively created a convertible bond.

Arbitrage

If a warrant is trading on a 10% discount, it is possible to buy the warrants, exercise them into shares, and then sell those shares directly in the market for a risk-free 10% profit. A classic arbitrage opportunity! Unfortunately, warrants almost never trade at a 10% discount. They may occasionally trade at a small discount of 1-2%, but arbitraging that would be difficult, as the potential profit would be offset by transaction costs of doing the trades. However, it's always worth being on the lookout for arbitrage opportunities. Although pure arbitrage opportunities tend to be rare - because everyone is looking for them- "quasi-arbitrage" opportunities (that are not 100% risk-free) abound. These might involve arbitraging a warrant against options, or other warrants.

1. Introduction 2. What is a warrant? 3. The warrant market 4. Advantages of warrants over shares - the magic of gearing 5. Further attractions of warrants 6. Disadvantages of warrants 7. Fundamentals - warrant terms 8. Fundamentals - intrinsic value and parity ratio 9. Basic analysis 10. Analysis - time value and premium 11. Analysis - gearing 12. Analysis - break-even and capital fulcrum point 13. Analysis -sample spreadsheets 14. Analysis - summary 15. Investing strategies 16. Dealing in warrants 17. Warrant exercise 18. Further topics 19. Further information 20. Conclusion

• Andrew McHattie on Covered Warrants