I need to start this article from a phrase “Leverage is risky”.
Many investors and market participants know this and use leverage products to capitalize on a particular market view.
Actually, I don’t think that Leverage is risky. It is additional possibility to earn money taking into account risks.
If you know how to limit your drawdown why should you avoid these products?
It said that leverage is appropriate for aggressive investors interested in the extra degree of price movements but even for those who want to hedge, for example FX exposure, these products can be usefull.
Therefore, generally leverage products allow short term participation in an underlying movements and hedging as well.
Best known leverage products are call and put warrants with fixed time to expiry, knock-out warrants which expiry early once a barrier hit and mini-futures with stop-loss levels.
Payoffs are shown in the picture below.
There is also a new Constant Leverage certificate introduced in autumn 2012 that grants the holder disproportionally high participation in movements in the underlying.
For many investors, call and put warrants will seem similar to options because they really have similar payoff functions and their value is linked to the value of the underlying.
The major differences however arise due to the very broad range of warrant products. Here is a comparision between Exchange traded Options and Warrants (OTC options a very similar to Warrants, therefore I don’t think there is a need to list differencies):
Exchange traded Options:
2. Possibility for short selling
3. Maturity is typically short
1. Issued by investment banks
2. Typically have longer maturities
3. Issued over a wider range of underlyings
4. Highly flexible
5. No short selling
6. Warrants typically have conversion ratio, that is a number of warrants required to gain exposure to one unit of the underlying asset
7. Used for structured products
Leverage products follow the underlying’s price movements with a leverage mechanism. Leverage is not measured by simple gearing. In fact, gearing and leverage are terms that are closely related to each other that it is often easy to confuse between them.
Gearing is calculated by dividing the asset price by the warrant price. If an underlying share price is 10 and a warrant is trading at 2, the gearing is five times. However, in most cases the figure is inaccurate
and not very meaningful when calculating the price of warrants.
Leverage is calculated by multiplying simple gearing by the delta. The delta is referred to as price sensitivity and indicates how the price of a warrant changes if the underlying asset moves by one unit. A warrant with leverage of five times might be expected to move five times as much in percentage terms as the underlying asset.
The Omega indicates the strength of a warrant’s leverage effect. The price of a warrant would rise or fall by approximately 5 % if the underlying price increase or fall by 1 % if the Omega is 5.
It is worth stating that there is a possibility to increase additional leverage in exchange for capped or limited upside potential.
Knock-out warrants compared to simple warrants carry an additional risk. This is due to knock-out event that makes them worthless as soon as it triggered and instrument matures immediately. Knock-out products are just very slightly affected by changes to the volatility.
Knock-out calls sometimes reffered as turbo call while knock-out puts reffered as turbo puts.
Mini futures have embedded derivatives making possible to invest in a leveraged long position in the underlying. These products are open-ended and have stop-loss levels which can trigger early redemption.
Stop-Loss level ensures that the investor do not lose more than the initial price paid.
The stop-loss level can be reset depending on the leverage, dividends, rolling of futures etc.
-Smaller initial investment due to leverage possibility
-No marging requirements
-Possibility to trade different underlying classes.
-Quanto features gives possibility to trade underlyings nominated in foreign currency
-Loss is limited by stop-loss feature or premium paid
-No volatility element in knock-out warrants as well as mini futures>
-Partial or no principal protection
-Credit risk of the isiuing institution
-Additional currency risk if the underlying is in foreign currency