*** You already use warrants, you just don't know it…!

*** Are options and warrants the same thing...?

*** Put or call? The decision is yours... and more…

From the desk of Julie Brownlee

Dear Investment Academy Reader,

With market mayhem continuing to rock the world, it takes bravery to trade, especially if you're new to the game. With the markets being so unpredictable, the last thing you want is to be caught on the wrong side of a trade and lose your life savings.

That's why today we're going to look at warrants. Warrants can be the perfect trading tool if your a novice trader as you know right from the start how much you can lose if your trade goes against you.

Let's run through the basics of warrants and how they work...

The first thing you should know about a warrant is it's: "The right, but not the obligation, to buy or to sell a specified quantity of an underlying asset, at an agreed price, on a specified date in the future."

That may seem a confusing prospect if you're used to only investing in straight equities, but let's put that official definition into terms we can understand.

Look at your everyday life to understand the concept of warrants

To start with, you're probably already using warrants - or may have used them in the past - to cover some of your everyday investments. Let me explain...

You can buy warrants as a sort of insurance, or hedge, to protect your capital or to profit if the market moves in your direction.

If you have car or house insurance you are, in effect, using warrants. You pay the insurance company a non-refundable premium (an amount you're prepared to write off) to protect your investment - the house or the car. You think there's a chance that your investment could fall in value (your car gets pranged, for instance) so you pay a premium to cover yourself. The value of your asset falls, but your insurance policy - your warrant - covers the loss and protects your investment. This is an everyday example of a long hedge.

Introducing the power of leverage

But warrants can also be used to speculate for a large return on your investment by putting up a relatively small amount of risk capital. Here's another everyday example you might have experienced to help you understand. Say a property developer is selling a new block of flats in an up-and-coming area. You like the look of them and want to buy, but they're not going to be ready for a year. To secure the flat at the current price of R500,000, you place a non-refundable deposit - the premium - with the developer, which is 10% of the purchase price, or R50,000.

This premium gives you the right, but not the obligation, to buy the flat for R500,000 in a year. Meanwhile, in return for the premium, the developer is now obliged to sell you the flat in a year's time for R500,000, if you want it. He has no choice.

A year passes and the price of the flats in that area have gone ballistic - they're now worth R850,000. You can now exercise your right to purchase the flat for R500,000, knowing you can sell it for R850,000. That's a R300,000 increase against a R50,000 stake - a R300,000 profit or staggering 600% return on your investment.

And that's what this Investment Academy (and those over the next few Fridays) is all about: How to make money from trading warrants. But first, I want to give you a little history lesson on the origins of warrants. Knowing where warrants come from will help you understand how these instruments work and why they can be so useful.

A brief history

Before we get going, I need to explain that worldwide there's a difference between options and warrants but, in South Africa, the two concepts are the same. While both options and warrants give an investor the right, but not the obligation, to buy a stock at a future date, globally options are financial instruments provided by financial houses, while warrants are issued by the company itself. In South Africa, both are issued by financial institutions.

Both options and warrants are derivatives. Derivative is a jargon term that covers any form of investment whose price or value derives from something else.

A derivatives contract can be formulated in several different ways. It can simply be an agreement to buy something from, or sell something to, someone at the indicated price at a specified time in the future. This is called a future.

But you might want to have the choice of buying (or selling) something - or not - at a fixed point in the future. In other words, you want to have the option of buying (or selling) it. But it isn't in your interest to do so; you don't want to be forced into it.

Warrants and options have been around since ancient times (as we saw in last Friday's Investment Academy). Merchants would pay a small amount of capital on anticipated crops or ocean-bound cargo.

When the crop was harvested or the shipment arrived, the merchant was given the first opportunity to buy the goods.

As investing evolved, so did options trading. Futures trading led to futures options. And as companies began to issue stocks, it was only natural that options would evolve to cover them as well.

Jumping ahead, using traded options as a financial tool became popular when, in 1900, the Put and Call Brokers and Dealers Association was formed in the US. The Association made it much easier for private investors to get into the market. Unfortunately, there were some problems with the system that allowed unscrupulous brokers to take advantage of those common investors.

In fact, use of options and related instruments got out of hand in the 1920s, exacerbating some people's losses when the market crashed. In the 1930s, Congress stepped in to try and regulate the options market.

Options were limited to strictly regulated over-the-counter transactions arranged by the Put & Call Dealers Association and endorsed by New York Stock Exchange members.

Options became mainstream again in 1973, when the Chicago Board of Options Exchange opened as the first American options exchange, with member market makers ready to serve investors with a two-way option market. Risk-takers who wanted to buy or sell options could now be rapidly accommodated.

The change from over-the-counter options was astounding. Contract terms were standardised, making them more accessible to the average investor, and their popularity skyrocketed. In fact, they became so popular that the Securities and Exchange Commission halted expansion of the industry in 1977 and spent years reviewing it. But finding nothing wrong, more exchanges were opened and more investments were optioned - including futures on commodity exchanges. Options had come full circle.

The point is, the options and warrants world is very big. But it's also regulated to keep everyone honest. In SA, the Financial Services Board (FSB), under the auspices of the Stock Exchange Control Act, ensures that dealing in warrants is regulated so you, the private investor, is protected. The close monitoring helps limit your risks, at the very least giving some fraud protection and recourse. That doesn't mean you don't have to be careful when trading, but it does mean trading warrants is as safe as trading stocks, bonds or property. (Of course, that doesn't mean that trading warrants is risk-free… but we'll get to that in a future issue.)

The most important thing to see is that, even though there are so many warrants to choose from, they all share the same basic fundamentals.

Once you understand how warrants in one investment work, you can apply those principles to investment options in completely unrelated fields. And that's called diversity.

Let's have a look at the two basic types of warrants you can trade...

What is a warrant?

Warrants give you the choice of buying and selling, or not, on fixed terms, for a period of time. For a small outlay, you can choose to exercise your warrant if the terms look attractive, or forfeit the small upfront premium if the deal's a no-no. Warrants always have shares as the underlying security, which is also their main distinction from options or forwards on currencies, for instance.

A warrant to buy something is known as a CALL WARRANT.
A warrant to sell something is known as a PUT WARRANT.

Call warrant prices move in the same direction as the price of the underlying security (usually just shortened to the "underlying", by the way), because the right to buy at a fixed price automatically becomes more valuable. Put warrant prices do the reverse. If the price of an "underlying" rises, the put warrant price will fall, because the right to sell at a fixed price becomes less valuable. A put warrant's price will rise if the value of the "underlying" falls.

Well, that's our delve into warrants for this week, but look out for next Friday's issue when you'll discover how warrants can make you big profits in a small amount of time and always with a completely known and controlled risk.

And, just before I go, the Investment Academy team loves to hear from you. If you have any comments or suggestions for future issues, drop us a note at iacomment@fsp.co.za. We're looking forward to hearing from you!

Happy trading!

Julie Brownlee
For the Investment Academy