Donna Block
Share World
They say variety is the spice of life. So if you’re looking to spice up your investment portfolio, warrants could be just the ticket. Warrants are a right to buy or sell a specific asset at a specific price for a designated period of time. They make it possible for investors to take a view on the upside potential of a stock or index with a call (buy) warrant or on the downside potential with a put (sell) warrant.
The cool part about them is that they’re cheaper than the underlying asset, trade exactly like regular shares on an exchange and can be traded through any registered Johannesburg Stock Exchange (JSE) broker.
Warrants have been around since the Eighties, and since Deutsche Bank launched them in South Africa two years ago, more than 1,6- billion warrants with a market value of R1,6-billion changed hands in a single year. Today there are four active issuers in the local market: Deutsche Bank has been joined by Standard Bank, ING Barings and United Bank of Switzerland. There are about 44 warrants now listed on the JSE, including a basket of financial services sector shares and a few indices.
According to investment bank Deutsche Morgan Grenfell, the South African market for warrants has increased in importance for two reasons: the appetite from investors for exchange-traded financial instruments that offer liquidity and leverage, and the fact that the Financial Services Board has ruled that pension funds are to treat warrants as securities.
Warrants are classified as derivatives and can be notoriously risky. Over the years, investors and speculators alike have attained some dramatic wins and, in some cases, even more dramatic losses in the derivatives market, giving these types of investment an aura of mystique and terror.
Derivatives should be used with caution. Used properly they can enhance a portfolio, creating a sensible investment structure; used unwisely they can take you to the cleaners. Warrants are within the investing scope of individuals, who can use them as leverage to reduce downside risk or as part of a high-risk/high-return strategy. Ralph Cope, head of warrant marketing at Deutsche Morgan Grenfell, said: “Warrants should be seen as a fine-tuning instrument, potentially adding high rewards to the least risk-averse section of the total investment portfolio.”
European-style warrants define the exact date on which the warrant may be exercised; United States-style warrants define the time span – you can exercise one at any time up to a
given date. South African warrants differ from their European and US counterparts as they are usually long term, ranging from one to six years. During that time, the warrant can be traded on its own, while the conversion rate is usually 10 warrants to a single share. The price of a warrant will be directly proportional to the price of the underlying asset, although they can exaggerate the movements taken by the underlying share price.
For example, you may buy a call warrant on stock that’s trading on the JSE at R41 and the strike is R40. The warrant expires in June 2001. If, at that stage, the stock is selling at R400, one may exercise the warrant and immediately sell it to gain a tenfold profit.
Something for nothing? Not quite. The cost involved in this type of strategy is called the premium, which can be anything from 10% to 35% of the current value of the underlying share. However, this is still considerably less than purchasing the shares for full price.
Using warrants as a trading tool allows investors to increase their exposure to a share without committing a large amount of capital. The price change, in percentage terms, of a warrant is therefore much greater than the price change in a share. The result is that it could provide the investor with a larger return on capital, while losses are limited to the premium paid.
But when using any kind of investment strategy there are always warnings – heed them. Warrants may not be appropriate for all investors, and the tax implications of warrants are uncertain. It is not clear whether private individuals who trade in warrants will be taxed in terms of Section 9(b) of the Income Tax Act. This clause states that those investors who repeatedly trade shares which they have held for less than five years will be taxed as traders.