Posted by kcchongnz > Nov 24, 2013 06:04 AM

Although many people like to use leverage to amplify return from the stock market, there are equal or may be even more of them scorn it. Yes, investing with leverage cuts both ends. So as a self proclaimed prudent investor, why do I advocate the use of leverage in investing in warrants? 

The theoretical value of warrant depends on the price of the underlying share, the exercise price, time to expiry, its volatility, dividend payment of the underlying and the risk-free rate. 
Let us take a warrant PJ Development Warrant C (WC) as an example how a leveraged instrument can be used as a financial risk management in investing rather than punting. 

Wc has an exercise price of 1.00 and expire in 7 years time on 4th December 2020. At the latest closing price of PJD and Wc at 1.28 and 35.5 sen respectively, the leverage or gearing is 3.6 times. Wc is in-the-money now but it is trading at a premium of 6%. This means that if you buy Wc at 35.5 sen and pay RM1.00 to send it to convert to PJD share, you are overpaying to own PJD shares by 6%. But who would be so stupid to do that ? There is precious time value in Wc which you won’t want to lose it by converting Wc to PJD share now. 

Let say I am bullish about PJD that the company will do well in the next 7 years and I believe that its share price will go up to RM2.00 within this 7 years before the expiry of Wc. Let say I first intend to invest in 10,000 shares of PJD for RM12800. If PJD share price goes up to RM2, I will sell it for a profit of RM7200, or 56%. Now instead of placing RM12800 at risk, what if I spend just RM4000 to purchase 11200 shares of Wc, or just a third of capital layout? 

I would achieve my goals if PJD really goes up to RM 2.00 within this 7 years as I would convert Wc and then sell in the market of the converted share of PJD for RM2.00. I would make the same amount of money, i.e. RM7200, with much lower capital layout and my return is now 182%. 

Of course the reverse is also true. If PJD share price goes down by 6% to RM1.20 and as the warrant is still in-the-money, I have to convert Wc as it is expiring, I would lose 44%. What if there is a major economic disaster and PJD goes bankrupt? One will lose all his money whether you are in PJD or Wc. But PJD shareholders lose RM12800, whereas Wc investors lose only RM4000. 

Yes, the beauty about warrant investors is warrant holders has the right but not the obligation to convert to the underlying share when it is out-of-the-money, i.e. when PJD share price is below RM1.00, the conversion price. Hence the downside risk of warrant is lower and limited to the lower cost of you investment in warrants. 

The table below shows the payoff of Wc with various prices of the underlying share price. 

PJD 1.00 1.20 1.40 1.60 1.80 2.00 
Wc 0.00 0.20 0.40 0.60 0.80 1.00 
Gain PJD -22% -6% 9% 25% 41% 56% 
Gain Wc -100% -44% 13% 69% 125% 182% 

KC Chong (Auckland 24 November 2013)

Thanks kcchongnz for his good post @ http://klse.i3investor.com/servlets/forum/900396884.jsp