TRADE OF THE MONTH

How to make sure investors don’t get the short end of the stick and end up with worthless warrants

Novice investors often think it sophisticated to say: “I’m going short on that stock.” Most would be stumped if you demanded details. Some may recite the How to Sell Stock Short for Dummies fourstep programme: step one, borrow a given number of the stock from your broker; step two, sell the stocks and pocket the proceeds; step three, wait for the price of the given stock to fall so you can repurchase them with part of the original proceeds; step four, return the borrowed stocks and pocket the profit.

The first snag is, good luck finding a broker willing to loan you stock to short if you are a retail investor — which is fortunate considering the disaster lurking at step three for investors without deep pockets when the price of the shorted stock rises instead of falls.

When brokers loan stock to their clients to short, it is on condition they keep enough cash in their broking account to cover repurchasing the borrowed shares. If the shorted stock’s price goes up instead of down, more cash has to be added to the account to cover repurchasing the borrowed shares at the now higher price.

Once a short seller runs out of resources to cover the rising price of their shorted stock in the hope it will eventually fall as expected, it’s game over — with catastrophic losses.

A safer way to bet a share price will fall in the coming months is to select from the range of warrants that trade on the JSE.

These are available via most retail stockbroking accounts, and a big advantage of shorting by buying “put” warrants instead of borrowing shares is your potential loss is capped at your initial investment.

Standard Bank is the main issuer of warrants in the local market, and a full list of the range available is at its website www.warrants.standardbank.co.za.

Of the 100 or so warrants Standard Bank has trading on the JSE, only about a third are “puts”, making the range of companies retail investors can short fairly limited.

For sake of illustration, I have selected a put warrant with code TRUSBP. Its long name is the cryptic “SB TRU 9500PP 40:1NOV18”.

Key information about warrants, besides whether they are put or call, is their strike price and date.

In this example, the strike price is R95, and the strike date is November 1 2018 for the put warrant. The 40 translates into one warrant representing onefortieth of an option requiring Standard Bank to buy a Truworths share for R95 on November 1 irrespective of what its price on the JSE is then.

What fraction of an option the warrant represents is important in valuing it. If Truworths’ share price has fallen to R80 on November 1, the value of the R95 option would be about R15, ignoring real world frictions like broking fees and taxes.

Since each warrant is only one-fortieth of an option, their value would be about 37c each.

For the put warrant to have any value on November 1, Truworths’ share price would have to be lower than R95.

When Standard Bank issued its TRUSBP warrants, Truworths was trading at about R100, at which time JSE punters valued the warrants at 29c.

At time of writing, the put warrant is “in the money” in that Truworths’ share price has fallen under R95 to about R83.

To keep with the clothing retailer theme, I’ll use “SB TFG R190CA 60:1AUG18” with code TFGSBA as the example of going long.

When these were issued on March 14, TFG’s share price was R216.35 and the call warrants traded at 68c, indicating punters were expecting it to be higher than R231 on the strike date on August 1.

TFG’s share price has subsequently declined to below its R190 strike price to trade at about R187, and the call warrant has fallen in tandem to about 19c.

A reason for buying a call warrant rather than a share you are optimistic about itself is that it can amplify your winnings, especially if you are a short-term investor with only a few months’ horizon.

But if you buy the shares, at least you get to keep them if their price falls.

Warrants that have fallen to the wrong side of their strike price by the strike date, on the other hand, are worthless.

A big advantage of shorting by buying ‘put’ warrants instead of borrowing shares is your potential loss is capped at your initial investment When brokers loan stock to their clients to short, it is on condition they keep enough cash in their broking account to cover repurchasing the borrowed shares