Monday, May 25, 2009

Black Swan Protected Portfolio

Do you know why I mainly play warrants? Well, one thing is the amount of money you can make when you are right. The other reason, I didn't really thought about until I read the book "The Black Swan" by Nassim Taleb. It protects your portfolio when a black swan event happens.

Let me elaborate on this idea. Refer to the table below. Let say you have 100k for investment. . Let say we invest all our 100k in equity. Consider a 50% gain in your portfolio (very good indeed!), you will get 50k. Now, let's consider the use of derivative such as warrants (aka options). Instead of putting 100k into the market, we only invest 10% or 10k in warrants. The rest (90%) is put into a near zero risk investment such as fixed deposit. The 2x warrant means that the warrant gives you twice the return as compared to the underlying share. A 8x warrant almost gives you the same return as using the complete 100k!

Now, what do I say black swan protected? Imagine one that when you wake up, a 9.0 earthquake has hit California or a terrorist has set-off a nuclear bomb in a big city. At the open, the market drops 50%. Look at the percentage loss that you will incur. By using warrants, your loss will be limited to 10k (the value cannot go negative). This is what I call protection from a black swan event.

Stock A 2x WA 4x WA 8x WA
Investment Equity 100,000.00 10,000.00 10,000.00 10,000.00
Cash 0.00 90,000.00 90,000.00 90,000.00
Winning Scenario
50.00% Value 50,000.00 10,000.00 20,000.00 40,000.00
Percentage 50.00% 10.00% 20.00% 40.00%
Losing Scenario
-50.00% Value (50,000.00) (10,000.00) (10,000.00) (10,000.00)
Percentage -50.00% -10.00% -10.00% -10.00%

You will think that I'm crazy of talking about 8x warrant. Look at the price movement of Genting and Genting-CO:

Genting Genting-CO Difference
Initial Investment 3.60 0.070
4.42 22.78% 0.120 71.43% 3.14x
4.60 27.78% 0.130 85.71% 3.09x
5.20 44.44% 0.185 164.29% 3.70x

Let say you manage to catch it at 3.60 or it's warrant at 0.070. At 5.20, you will have already earned 44.44% (ignoring transaction cost). But if you buy the warrant instead, your return will be 3.7x bigger, which is 164.29%!

Now look at Bursa and Bursa-CL:
Bursa Bursa-CL Difference
Initial Investment 4.40 0.085
5.75 30.68% 0.245 188.24% 6.14x
6.20 40.91% 0.315 270.59% 6.61x
7.30 65.91% 0.535 529.41% 8.03x

If you been lucky to catch it at the bottom, the return from Bursa will be 65.91% but Bursa-CL will give you a return of 529.41%. This is 8.03x more!

To achieve this, you need the following:
1. Favorable exercise price and expiration for the warrant.
2. To be able to time your purchase.
3. Your purchase move strongly (i.e. strong trend).

I hope that you get the idea. Of course the theory sounds nice but the implementation is difficult. There are two purposes why I wrote this. The first one is to present the black swan portfolio protection theory. The second is to encourage more people to trade in warrants. Some warrants are really illiquid. The spread is terrible. The volume is terrible. Anyhow, before you jump into the warrants, make sure that you have the necessary knowledge and skills. If you buy a call warrant when the share is on the way down, you will get hit hard! Don't say I didn't warn you.

1 comment:

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