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Do warrants warrant my trust?

A friend of mine has made a lot of money using warrants on the advice of his adviser and he is encouraging me to have a go at them but I recall your advice that you should never invest in anything that you don’t understand. Could you explain them to me and tell me what you think of them?

The ASX defines a warrant this way: “A warrant is a financial instrument issued by a bank or other financial institutions, which is traded on the Australian Securities Exchange’s equity market. Warrants may be issued over securities such as shares in a company, a currency, an index or a commodity.”

Let me add some explanation.

A warrant gives you something that the experts call leverage, which means that for a share you can bump up your returns. Now before I go much further, I have to explain that leverage works in two directions – to magnify your profit or to magnify your losses.

Let’s take an example of a call warrant up against buying an ordinary share. This comes from the ASX website which has some good educational stuff.

“XYZ shares are currently trading at $20. A call warrant gives you the right, but not the obligation, to purchase XYZ shares for $20 from the warrant issuer. The warrant price is $0.73. Now assume the share price rises to $21 on the same day and the warrant price goes to $1.38.”

If you bought the share, you would have forked out $20 to pick up $1 profit, which is a return of five per cent. But if you paid only 73 cents for an XYZ warrant, which went to $1.38, you have made 65 cents on an outlay of 73 cents, which is a return of 85 per cent.

Let’s look at this example but assume the share price falls to $18 when the time on the warrant expires. Here’s the ASX again:

“If the share price falls to $18 at expiry of the warrant, the warrant would expire worthless. While you would only lose 10 per cent on the share, – $2 on the $20 invested – you would have lost 100 per cent of your investment in the warrant.”

Yep, warrants work in both directions, bumping up profits and losses.

By the way, the ASX has more info in a booklet called “Understanding Trading and Investment Warrants”.

I recommend you do a bit of homework on these before you risk your hard-earned money on warrants.

For advice you can trust book a complimentary first appointment with Switzer Financial Services today.

Important information: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. For this reason, any individual should, before acting, consider the appropriateness of the information, having regard to the individual’s objectives, financial situation and needs and, if necessary, seek appropriate professional advice.

Published on: Tuesday, October 05, 2010

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