Common misconceptions Part I

Structured products such as derivative warrants (known as warrants”), inline warrants and CBBCs are very complicated financial instruments that come with many misconceptions. If you are interested in investing in these products, you should have a clear understanding so as to minimise the risk of making mistakes in your investment.

Among the warrants and options listed and traded on the HKEX, some are linked to a single stock. They give the buyer the right to buy or sell the underlying stock at a pre-set price within a certain time.

However, warrants only allow investors to have a long position (i.e. to buy a warrant), while options including stock options allow investors to take both long and short positions (i.e. to buy or sell an option). Some investment strategies are only realised through short position, such as the Covered Call Writing strategy where investors sell the call options while holding the underlying stocks with the hope of increasing yield. Another example is the Short Put strategy where investors sell the put options with the hope of lowering the cost of buying the underlying stocks. Please refer to the FAQs on the HKEX website to know more about stock options.

Learn more about the differences between warrants, options and futures

Many investors invest in warrants or CBBCs because they can gain exposure to the movements of the underlying asset price (or level if the underlying asset is an index) at a fraction of its price.

In reality, the leverage effect of warrants and CBBCs should work as a hedging tool providing effective risk management of the underlying assets and investment portfolio. Similar to an insurance policy, with a relatively small investment, you can protect your portfolio against severe losses and cash flow disruption caused by adverse market movements. You may consider put warrants or callable bear contracts to mitigate the risks if you expect short-term price adjustments of the underlying assets but do not want to sell them. You may follow the formula below to determine the quantity of put warrants or callable bear contracts required to fully hedge the risks:

Put warrants or callable bear contracts = (amount of underlying assets/ hedge value (%) x conversion ratio)

When the underlying asset price declines, the underlying asset or investment portfolio may suffer a loss, but the theoretical price of the related put warrant or callable bear contract may rise and the profit made may fully or partially cover the loss. You may not need to go for full hedging as you may adjust the hedge ratio based on the market outlook, your confidence level and risk appetite. For example, you may hedge 1/3 or 1/4 of your portfolio. The maximum loss of using warrants or CBBCs for hedging is limited to the money invested.

Know more about Delta and conversion ratios: