How to choose the right warrant?

A warrant is a derivative instrument whose value is dependent on the underlying stock. Warrants offer investors leverage. Typically, with the same investment outlay, the investor would be able to buy many more times the warrants than if he had bought the underlying stock directly. There are nearly hundred of warrants listed on the Bursa Malaysia and it is common for there to be more than one warrant on each underlying stock. Before deciding on which warrant to invest in, a potential investor may consider the following pointers before taking the plunge in the universe of warrants.

1. Know the Product
   Investors should understand the dynamics of how the product works and the associated risks before buying any investment.
2. Have a view on the where the Market is headed
   The performance of warrants is tagged closely to the price performance of the underlying stock. An investor with a bullish view on the underlying stock would consider buying a call warrant.
3. Determine an Investment Target
   Any investor may choose to set a deadline for the underlying asset to reach a target price. If the underlying stock fails to reach the target price, the investor should reevaluate his/her positions. Warrants are subject to time value decay and the closer a warrant is to its expiration date, the less it is worth.
4. Select the best warrant
   Every warrant is unique – it has a unique exercise price, maturity date and effective gearing level. Investors should choose a warrant in light of his investment targets and objectives and continually be monitoring his risk/return profile.

Advantages

1. Low cost
   Warrants are an alternative to buying the underlying share that cost a fraction of the price of the shares. Brokerage costs that result from trading the warrants are also correspondingly reduced.
2. Sensitivity to share price movements
   In percentage terms, prices of warrants are more sensitive to changing market conditions as compared to their underlying shares. This implies that warrants can give the investor greater exposure to share price movements at lower the cost.
3. Limited downside
   The potential loss to the investor of warrants is the warrant premium, which is usually a fraction of the cost of investing in the underlying shares. The upside on the other hand, is unlimited.

Risks

1. Buying a warrant is expressing a directional view on the underlying share. If the investor’s view on the price movement is wrong, the maximum loss to the investor is loss of the warrant premium.
2. Depending on the gearing effect of the warrant, the price of warrants is more sensitive to changes in market conditions than the price of the underlying share. In adverse market conditions, this could potentially result in a greater percentage loss (in the case of call warrants) to the investor.