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Surviving In This Volatile Market
Perspective | 21 May 2010
By: Xavier Lim
Articles (51) Profile

Investors’ confidence has once again taken another hit. One of the most terrifying moments in Wall Street’s history, the Dow Jones Industrial Average plunged 992 points before ending the day down 348 points, or 3.2%, on 6 May.

While everyone was not surprised to see the stocks heading south due to Greece’s economic meltdown, mounting pressure on the euro and an uncertain outcome in Britain’s parliamentary elections, the extent of the intra-day fall was mind-boggling to say the least. The Dow tumbled 330… 660… 992 points within minutes. Then, it came roaring back to life like a tsunami.

It was only when the European Union and the International Monetary Fund agreed to commit nearly US$1 trillion to stabilize Europe, did investors decide to return to a badly shaken market. On 10 May, the Dow closed at 10,785, up slightly over 400 points, or 3.9%, its biggest daily gain in 13 months, and enough to bring the bellwether index safely back into positive territory for the year. Those who betted against the market were caught.

Betting Against the Market

In a market correction, betting against the market seems to be a “correct” thing to do. There are a lot of ways to do that, but perhaps the easiest, most straightforward way would be to buy put warrants or options. So, for traders/speculators ready to take that step and go against the market, it is important to have some understanding of the various factors influencing warrant prices.

Price risk is the risk associated with changes in the market value of the warrant. Changes in the value of the underlying security affect the price of the warrant. If its exercise/strike price is below the stock price, a warrant is said to be out-of-the-money and hence has no intrinsic value. On the other hand, if its exercise/strike price is above the stock price, the warrant will have an intrinsic value and is in-the-money.

Investors should also be aware of the effect of time decay. Time value declines as the warrant approaches its date of expiry. For a warrant on a stock that does not perform, the former’s value will decrease everyday. This is also true if the price of the underlying stock remains stagnant. If the warrant is out-of-the-money at the expiry date, then it will be worthless. You may wish to read more on warrants, structured warrants, options and CFDs.

May Not Be So Wise

Most of the time, investors bet on stocks to appreciate and hold for days, weeks or even years to ride out the market volatility (only if they invest in companies with solid fundamentals). However, there is a huge difference when it comes to investing in warrants predominantly due to the 2 risks associated with warrants mentioned above. It is also because of these 2 risks that create an emotional uneasiness for warrant investors/traders, resulting in many of them losing money.

Moreover, warrants may fail to deliver that return you are investing for over time. Allow this writer to show you why. Let us say that if you invest $1,000 in a put warrant. The market goes against you and gains 3% on the first day; your investment fund loses 10% that day. The next day, the market reverses course, giving back that 3%. Your fund moves 10% in your favour. You may think that your fund has regained to its initial amount. You are wrong! When the fund lost 10% of its value, your holdings dropped to $900. When it gained 10% on the second day, your account added 10% of that lower amount, leaving you with $990 (all transaction costs have not been factored in). So, even though the market was flat, you have lost 1% in two days. Got it?

Due to the high-risk and high-return nature of the warrants, you may lose more than 50% within days. Any investment that can lose that much within a short time span is definitely not a wise investment. Please remember that corrections can work both ways – downtrend or sideway movements. So, if you short the market using put warrants, you may want to revisit your thinking, because if your judgment is late, faulty or incorrect, you will pay a hefty price.

Then What Should We Do?

We want to buy when everyone is selling and sell when everyone is buying because we all know it is bad to follow the herd. As what this writer has suggested in the previous article, ‘Sharing Effective Investment Strategies‘, you should 1) diversify your investment portfolio; 2) invest in companies or simple products that you understand; 3) establish an appropriate asset allocation model in accordance to your financial goal and risk tolerance; 4) rebalance your asset allocation periodically (a good way of market timing); and 5) stay on top of your investment plan and be more attuned to the valuations of a stock.

Put it simply, review your investment portfolio to see that if your investment goals are still on track. People who stick to their plan have fared much better over the past 14 months than those who panicked and sold at the March 2009 bottom. Remember, having a cash reserve would reduce some of your worries, as you will not have to sell stocks either out of fear or need.

Armed with an arsenal of investment knowledge, Xavier is the Senior Research Editor at Shares Investment.

Please click here for more information about this author.

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