Although warrants are generally purchased for their high appreciation potential, their exceptional leverage also makes them useful for hedging. A warrant hedge consists of a long position in a warrant and a short position in the underlying common stock. Typically, the expected return from such a hedge is less than might be realized by either the long warrant or the short stock position. However, a properly constructed hedge offers excellent earnings potential with substantially less risk than either the long warrant or short stock position.
One of the main criteria investors should consider when selecting a warrant for a hedge is the degree to which the warrant’s price is expected to change on a given change in the price of the underlying common stock. These “leverage projections” are shown on our subscriber website. They can also be found in our daily Warrant spreadsheet, also on the website. When the warrant’s upside leverage exceeds the downside—the warrant’s price is expected to rise faster than it will fall—the opportunities exist for a successful hedge. The greater the difference between the projected upside and downside price movement, the greater the hedge profit potential. If a warrant’s leverage is neutral or unfavorable—that is, its price is expected to fall faster than it will rise--the hedge’s profit potential is limited.
Another important consideration for selecting a hedge candidate is…(read more)