I've heard people say that warrants can be used as a hedging tool. If so, how can I as a retail investor trade warrants for hedging purposes?

First of all we should establish the meaning of the word ‘hedging’. Hedging is the process whereby an investor enters into a trade to offset some risk.  Very often this risk may arise  due to an existing holding  of an asset. Hedging is a very common practice in many financial markets and across many different asset classes. For example, if a Singapore investor bought an investment property in another country they will be exposed not only to the value of the property but also to the exchange rate of that country. The investor may choose to reduce the risk of future exchange rate changes by buying a currency swap or something similar, this process is called hedging their risk.

In stock markets hedging can be achieved through a number of different methods. One of the common methods is through the use of options or warrants.  There are two basic ways to use warrants as a hedge, hedging against a ‘fall’ or hedging against a ‘rise’ in share price. For example, if you had a large holding in XYZ shares and you were concerned that the share price may fall following an upcoming announcement  but you didn’t want to sell your holding, you could protect the value of your investment against a fall by buying a put warrant over XYZ shares. If your forecast comes true and the share price falls you will make a loss on your share holding. However, the loss can be partially/totally offset by the profit you make on your put warrant holding.

The other common form of hedging is to use warrants to hedge against a rise in share price.  For example lets say that you have a holding in ABC shares and you had to sell your holding as you needed the funds for use elsewhere. You still however have a strong view on ABC and are confident that it will appreciate in value in the short term. In order to hedge against the risk of missing out on future gains you can buy some call warrants over ABC to maintain some exposure to movements in the share price. As warrants are a geared investment you will be able to achieve exposure for less capital than buying the underlying ABC shares. Through this process you have maintained exposure to the underlying shares while getting access to some of your capital for use elsewhere. You have ‘hedged’ yourself to ensure you don’t miss out on future movements in the share price.

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