Buying put warrants for leverage

Are you looking to leverage into a falling market?

If you follow overseas markets, why not trade call and put warrants on an international index to reflect your view of market direction - whether bullish or bearish.  Index warrants can give you an easy way to gain a leveraged exposure to the broader market with minimal capital outlay.
 
Currently, ASX quotes warrants issued over several leading domestic and overseas indices. A unique 3-letter code identifies each index, for example the S&P 500 is XSP. Visit 'understanding warrant codes' for more.

Example

You are short-term bearish and expect the S&P 500 index to fall within the next month. Trying to maximise your return, you decide to invest $5,000 in a S&P 500 index put warrant.

Warrant code                      XSPWOT                   
Warrant price $0.39
Underlying asset     S&P 500 index
Warrant type Put warrant
Exercise price 1,100
Expiry date 3 months
Index multiplier US $0.005

The table below compares the results of investing in the put warrant to the performance of the index.

S&P 500     XSPWOT   
Buy price 1,140 $0.39
Sell price (1 month later) 1,086 $0.51
Return on investment (%) -4.7% 30.8%

As a result from the drop in the index by 4.7% the put warrant increased in value. Due to the leveraged exposure the trading warrants provide, the warrant price increased to $0.51, representing a 30.8% return on investment.

If you have a bullish view, purchasing call warrants allows you the opportunity to participate from a rise in the underlying index, with limited risk. 

Other factors to consider

Exchange rates
When trading overseas investments, you must take into consideration both the underlying price movements and the fluctuations in exchange rates.  As the index is expressed in US Dollars you are exposed to the performance of the AUD/USD exchange rate. In the case of US indices, the index warrant is priced in USD then converted into AUD for Australian investors. 

Applying this to the previous example, if the AUD/USD exchange rate were higher or lower, this would impact the warrant price in the following manner:

Exchange rate (AUD/USD)       Warrant price    
US $0.65 A $0.52
US $0.70 A $0.48
US $0.75 A $0.45

A rising Australian Dollar will negatively affect the warrant price, while a falling Australian Dollar will have a positive effect. It is recommended that you consider both the performance of the index and exchange rate when trading international index warrants.

Time zones
As overseas markets are closed during the trading times of the Australian market, warrant issuers may use a corresponding index futures contract as a price reference for the index warrant.  For example, S&P 500 index warrants are generally priced based on the S&P 500 futures contract.

Main benefits of the strategy

  1. Participate in the performance of either a domestic or an international equity market with one product
  2. Leveraged exposure to a fall in the index. Index warrants are one of the few ways to gain exposure to a rising or declining market
  3. Loss is limited to the amount invested
  4. You can use index put warrants to protect the value of a portfolio of shares tracking the index

Main risks of the strategy

  1. If the index moves unfavourably, the index warrant will reflect this in terms of leveraged losses, limited to the initial investment amount 
  2. Time decay works against a bought put warrant
  3. For foreign index warrants, fluctuations in the exchange rate - AUD vs USD for example, can impact on the performance of your trade.  A strengthening in the AUD will reduce the profitability of trading foreign index warrants.

Breakeven Point
In order to calculate the breakeven point, you need to convert the warrant price from Australian dollars into US Dollars. Then you can transfer the US Dollar amount into index points by dividing the US Dollar price equivalent by the index multiplier.

Breakeven index level
=1,100pts – ($0.39 x $0.688 / 0.005) 
=1,100pts – 54pts
=1,046 pts

Maximum profit
=(1,100 x 0.005 / $0.688) - $0.39
=$7.60

Disclaimer
The information is for educational purposes only and does not constitute financial product advice. ASX does not represent or warrant that the information is complete or accurate. You should consider obtaining independent advice before making any financial decisions. To the extent permitted by law, no responsibility for any loss arising in any way (including by way of negligence) from anyone acting or refraining from acting as a result of this material is accepted by ASX.