Buying insurance for your stocks using option (structured warrant)

After reading my previous articles on option (structured warrant) (Read more here), (Read more here), many people asked me about the high risk level associated with option (structured warrant) trading.   Thus, I am writing this article to share my answer to everyone.

Yes.  It is indeed very risky if you trade naked call or naked put warrant.  Buying or selling a call or put warrant without owning the underlying asset is termed as naked call or naked put trading. 

Example of naked call warrant trading.

You do not own any stocks listed on Bursa Malaysia.  You have a strong opinion that the market will go up soon.  So you buy the call warrant of FBMKLCI.  By doing this, you expose your position to the following risks.

1.       Time risk – Warrant has expiry date.  Its value decays over time.  In my previous calculation (Read more here), the warrant value reduces about 4% in one week and will eventually reduce to zero value at expiry date if it is out of money.

2.       Volatility risk – The price movement of warrant is very huge.  It is not uncommon to see warrant value moves up or down by 30% in one day.

Why trade warrant if it is so risky?

In fact, the intention of financial derivative is for hedging purpose.  It is a very useful financial instrument for risk management.  Investor could utilize warrant trading as buying insurance for your portfolio.  One example is the “Protective Put” strategy. 

You own a diversified portfolio consisting Bursa Malaysia stocks using fundamental analysis, and you plan to use buy and hold strategy to achieve long term capital growth.  Lately, the market moves to new high and you are anticipating a market correction soon.  It may not be appropriate for you to sell all your stocks and then buy them back after the market correction, but you would like to minimize your risk.  Thus, you apply the “Protective Put” strategy by buying some put warrant of FBMKLCI.  Table 1 is the possible outcome of your strategy if the market correction happens.

Table 1

Market loss	Stock Portfolio value	Put warrant gain	Put warrant value	Total Portfolio value
1.00%	89100	9.00%	10900	100000
2.00%	88200	18.00%	11800	100000
3.00%	87300	27.00%	12700	100000
4.00%	86400	36.00%	13600	100000
5.00%	85500	45.00%	14500	100000
6.00%	84600	54.00%	15400	100000
7.00%	83700	63.00%	16300	100000
8.00%	82800	72.00%	17200	100000
9.00%	81900	81.00%	18100	100000
10.00%	81000	90.00%	19000	100000

Assuming the value of your diversified stocks portfolio is RM90,000, and you hold RM10,000 cash.  If you choose not to do anything during the market correction, your stock portfolio value will reduce to RM81,000 if the market drop 10%.  Your total portfolio value after market correction will be RM91,000.  If you use the cash to purchase RM10,000 of FBMKLCI put warrant with gearing of 9x, it serves as the insurance to “protect” your stock portfolio value because put warrant will appreciate during market downtrend.  As such, your total portfolio value will remain at RM100,000 even the market dropped 10%.

What if the market correction did not happen and you did purchase the put warrant?  Table 2 shows outcome of this scenario.

Table 2

Market gain	Stock Portfolio value	Put warrant loss	Put warrant value	Total Portfolio value
1.00%	90900	9.00%	9100	100000
2.00%	91800	18.00%	8200	100000
3.00%	92700	27.00%	7300	100000
4.00%	93600	36.00%	6400	100000
5.00%	94500	45.00%	5500	100000
6.00%	95400	54.00%	4600	100000
7.00%	96300	63.00%	3700	100000
8.00%	97200	72.00%	2800	100000
9.00%	98100	81.00%	1900	100000
10.00%	99000	90.00%	1000	100000

The put warrant will depreciate as the market moves up, but your total portfolio value will remain at RM100,000 because the put warrant loses are offset by the stock portfolio appreciation.  This is a very attractive strategy because it helps to “protect” your capital even you made a wrong market prediction.

If you use structured warrant as a speculation vehicle, it is very risky!  However, if you use it as a hedging tool, it is a very good instrument!

Disclaimer:  The above structured warrant strategy is specifically designed for the paper portfolio in this article.  An appropriate hedging strategy requires rigorous analysis on the portfolio composition, market correlation, derivative instrument characteristic, and investors’ risk tolerance.  Investors who are interested to utilize structured warrant as hedging tool shall seek for professional advice.  The author disclaims all liabilities arising from any use of the information contained in this article.