« Aztech Earning Preview. What to expect? | Home | US Market Morning Note »
By Pehon | July 25, 2007
A few months back, one of my reader requested that I explain the concept of buying warrants as an insurance for your portfolio.
Let me paint you a scenario. You’re holding a portfolio of STI stocks (ie Singtel, Capital Land) worth $100,000. However, for some reason or another, the indications of a possible short term bear market is imminent.
There are 3 things you can do.
- You can take profits. However, as we have seen over the last few months, the signs are never clear. You may just sell your stocks and suddenly see the bulls charge again.
- You can sit there and do nothing. This is my recommended method for long term investing.
- You can take an insurance, in the form of warrants.
We’re only interested in the 3rd method in this post.
Please take note that I do not advocate speculative trading. What I’m trying to share here is for you to effectively reduce your risk in a falling market, while hanging on to your long term investment.
So to safeguard your investment in a highly possible bear market, you could buy a STI put warrant (since your portfolio consists of STI stocks). For example sake, I’ve chosen the following warrant.
STI 3400 DB EPW071031
Its strike level of 3400 and currently has the latest maturity date of 31 October 2007.
Let us assume the STI is 3600 today. Before buying, you’re already expecting the STI to be down by 200 points to 3400 in a months time due to the market instability. Thats about a 5.55% drop in the STI. And since you own STI stocks, your portfolio will drop 5.55% as well. Hence you decide to buy an insurance of $6000 (5.55% of your $100,000 portfolio) today at $0.175 (data from 25-07-07).
Going by the Implied Volitility (IV) of 20.78 (the IV and the following calculation is from sg.warrants.com), if you were right, and the STI were to drop to 3400 on 27-08-07 (25-07-08 is a Saturday), you’re looking at a warrant price of $0.338, or a 93.14% gain in your warrants. And so you decide to sell your warrant on 27-08-07
|
|
Value Before |
Value After |
Change |
| Portfolio of STI Stocks |
$100,000 |
$94,445 |
-$5555 |
| STI 3400 DB EPW071031 |
$6000 |
$11,588.4 |
+$5588.40 |
|
You see, you don’t have to hold on to your warrant till it expires. If you do, you risk seeing the market recover, closing above the strike price of 3400, leaving your warrants worthless.
As you can see from the above example, if you were to not buy the insurance, your portfolio would be down $5555.00. However, since you made the right call, and bought the right warrant, and realising the profits from your warrant, intead of a loss of $5555, you’re looking at a gain of $33.40 in a bear market.
You’ve succesfully protected your portfolio. This is useful if you invest with margin. It could save you from a margin call.
You could apply the above concept to Warrants linked to individual stocks. You could apply the same example to a portfolio that isn’t STI stocks. Its really up to your imagination. Just trade with caution, pay your dues in terms of homework, before you invest.
PS. the above example is just for illustration purposes only. I don’t believe the bear market is here. In fact i believe we’re in a bull market, so strong we have never seen before.
Topics: Quick Lesson |
Comments
