Benefits and risks of investing in warrants

Warrants can be used to complement a number of investment and trading strategies. There are risks to consider when investing and trading in warrants.

Benefits of warrants

Despite their diversity, warrants offer some common benefits. These include the ability to use leverage and the security that you will never lose more than your initial outlay.

Warrants can provide you with exposure to an underlying asset for a lower upfront cost than direct ownership. As a result, a warrant gives you leverage, which means small changes in the value of the underlying asset result in larger changes in the value of the warrant. This can magnify gains when asset values rise, but it can also magnify losses when asset values fall.

For example, a 5% change in an underlying share price could see the market value of a warrant over that share increase or decrease by 20%, depending on whether the share price rises or falls.

Warrant issuers have a large amount of flexibility in how they structure warrants, which allows warrants to be tailored to potentially meet a variety of investor needs. For example, index MINIs may appeal to investors looking for exposure to moves in a particular index over a short period of time, while instalment warrants may appeal to investors looking for long-term leveraged exposure to ASX-quoted securities.

The maximum amount a warrant holder can lose is the amount they paid for the warrant. The loan amount associated with the warrant is non-recourse. For example, if the value of the underlying asset ends up below the loan amount, the investor can walk away from the warrant. It is this non-recourse feature that allows warrants to be used as a way to leverage within a self-managed super fund.

Some warrants may provide you with the opportunity to profit from movements in the market or a sector without necessarily owning a large portfolio. International index warrants, international equity warrants and currency warrants allow you to gain exposure to overseas and other markets. Some warrants and structured investment products may also give you exposure to overseas underlying assets, such as shares, exchange traded funds (ETFs), indices and debt.

Risks of warrants

There are certain risks involved in investing and trading in warrants. Different warrant series will have specific risks and risk profiles. You should only invest in warrants if you understand the nature of the products (specifically your rights and obligations) and the extent of your exposure to risk. Before you invest, you should carefully assess your experience, investment objectives, financial resources and other relevant considerations, and discuss them with an accredited derivatives adviser.

Warrants can provide you with exposure to an underlying asset for a portion of the price. As a result, a warrant gives you leverage which means small changes in the value of the underlying asset result in larger changes in the value of the warrant.

While this can magnify your gains when asset values rise, it can also magnify your losses when asset values fall. You should ensure you understand and are comfortable with the level of leverage within any warrant you hold, and the accompanying risk.

This is the risk that you may not be able to sell your warrants for a reasonable price in the market. This could be because there are insufficient orders to buy your warrants or the price at which others are prepared to buy them is very low. In some cases a lack of liquidity in a warrant series may be due to a lack of liquidity in the underlying instrument.

Most warrants have a limited life and can no longer be exercised after expiring. Investors in these warrants do not benefit from any upward movement in the share price after expiry. If you hold such a warrant until expiry and choose not to exercise it, then you may receive only a reduced payment or lose your initial stake altogether.

Each warrant is a contract between the warrant issuer and you, and there is always the risk that the issuer (or its guarantor, where relevant) will not perform its obligations under the warrant, causing losses. Neither ASX nor its subsidiaries in any way guarantee the performance of the warrant issuer or the warrants issued. Therefore, you must make your own assessment of the risks associated with dealing with the warrant issuer.

In certain circumstances of broker misconduct, you may be able receive compensation from the National Guarantee Fund if you have bought or sold warrants on ASX. However, you have no recourse to the Fund if you have bought warrants directly from the issuer.