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Using equity put warrants in a falling market

Are you looking to profit from a falling market? Given the recent market activity, traders are increasingly looking to trade a falling market through put warrants. Since there are a number of issues surrounding short selling it can be rather cumbersome when trading small volumes. Put warrants provide you with an investment vehicle that can profit from a falling market.

Comparison: short selling RIO shares vs purchasing RIO put warrants

Let's assume that you are bearish on RIO and have the view that the share price will fall over the next few days.  Lets compare the returns of buying $5,000 of the following RIO put warrant to short selling RIO shares.

Warrant description: purchased an at-the-money RIO put warrant (ASX code RIOWZP)

Warrant code RIOWZP
Warrant price $2.28 (1.12.08)    
Underlying asset                  RIO FPO
Warrant type Put warrant
Exercise price $45.00
Expiry date 26.02.09
Conversion ratio 6

The table below compares the results of investing in the put warrant to short selling RIO shares.

  Short RIO shares      Buy RIOWZP   
Capital outlay/exposure      $5,000 $5,000
Number of units 117 2192
Entry price (1.12.2008) $42.70 $2.28*
Exit price (5.12.2008) $32.00 $3.19*
Profit (per unit) $10.70 $0.91
Total profit $1,251.90 $1,994.72

* Based on valuation price of RIOWZP put warrants.

Conclusion: Put warrants provide greater returns for a smaller capital outlay

In the above example using put warrants have allowed us to generate a greater profit compared to short selling RIO shares, using put warrants has achieved almost a 40% return on our investment. This highlights the efficiency in using put warrants to trade a falling market as opposed to short selling shares.

Put warrants provide you with an investment tool to trade a declining market with the added benefit of leveraged exposure without the risk of margin calls.

Main benefits of the strategy

  • Leveraged exposure to a fall in an underlying share. Put warrants are one of the few ways to gain exposure to a declining market
  • Loss is limited to the amount invested
  • No margin calls.

Main risks of the strategy

  • If the share price moves unfavourably, the put warrant will reflect this in terms of leveraged losses, limited to the initial investment amount 
  • Time decay works against a bought put warrant.

Golden rules to follow when using trading warrants

  • Always have a strong directional view on the underlying stock
  • Choose an exercise price that suits your view of  the stock
  • Keep an eye on volatility
  • Plan entry and exit points when trading
  • Paper trade before trying a new strategy.

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