Today I want to cover a topic I talked about during the most recent quarterly Zoom call with Strategic Trader subscribers.
On the call, I wanted to share a bit about how I think about risk when it comes to the warrants we trade. Something I always mention whenever I can. Because it’s that important.
As many of you may know, warrants are very speculative investments. They’re just as easy to trade as stocks. But they resemble options in a way.
That’s part of the reason they’re my favorite speculative tool. They can give me leverage on the underlying stock. All while being simpler than options.
In fact, they’re so easy to trade that I always tell newcomers I can teach them how to trade warrants in five minutes or less. Regardless of experience.
However, the way I look at speculative trades like this also surprises some.
Let’s Talk About Risk
Not long after our quarterly call, subscriber Shawn reached out to me on our community Slack server with a great follow-up question.
I created the Slack server exactly for that reason. So members can reach out to share. Or ask questions that I can respond to quickly.
Here’s what Shawn asked me:
“On the call last week you said to only put about 2% of your portfolio into warrants. Is there a minimum size portfolio a person should have before investing in warrants? I know you are not supposed to give personal advice. However, are there some general guidelines you could share with me?”
It’s a great question. And I want to go into some detail on how I view warrants both from a risk perspective and how I allocate to them.
First, let’s talk about risk.
The first question most people ask me when it comes to trading warrants is “How much can I make?”
The answer I give them is usually not what they expect. That’s because I don’t think about how much I can potentially make. That’s the last thing on my mind.
Instead, I focus on risk first. And go from there.
As I told Shawn:
“I know a lot of people focus on the gains. I actually don't. I focus on what I could lose first and go from there. Knowing that historically, the gains eventually come. Sometimes in waves. Sometimes randomly. It's playing for time, which is why I like having these longer timeframes with warrants of 3, 4, 5 or more years.”
What you’re willing to risk is what you should think of before you put a dollar into any investment. Whether that’s a position in your core portfolio or a speculative trade like warrants.
When I trade warrants, I always think, what amount could I invest that wouldn’t hurt me if the position went to zero? Because that’s always on the table.
Before I became a professional investor, I didn’t do that. I always thought about how much I could make. I dreamed of what I would do with the massive gains I thought would come easy.
I never thought about what would happen if I lost.
Focusing on risk before return really changed things for me. Looking back, I can say it helped improve my performance quite a bit. (And making my investing more systematic helped even more. Something I discussed in previous posts here and here)
That’s why I’m always telling readers every chance I get to do three things when it comes to speculating. First, never bet more than you can afford to lose. Second, use limit orders to control how much you buy or sell for. Third, be patient. Things don’t always go your way right away.
Those things help take the emotion out of any volatility you may see when trading.
And so does your allocation.
Cap Your Positions
As I mentioned on the call, every quarter, I like to go through the exercise of adding up how much I have invested in warrants. Then see what percentage they make up of my overall portfolio.
I showed members that my current allocation to warrants was 2% of my overall portfolio. Which is why Shawn initially brought up the 2% figure.
Personally, though, I like to have at least 5% of my portfolio allocated to warrants. That exercise helps me decide whether to put more money into warrants. Or to pull back.
So I make adjustments as needed. Which, at 2% as of the end of Q3, I know I need to put more money into warrants this quarter to get back to that 5% target.
But that’s not all. As I told Shawn:
“Really what it comes down to is I look at it from what percentage of my portfolio could I lose in these types of securities and not lose sleep? If every warrant went to 0 and I lost 5%, would that be the end of the world? No. I'd be just fine.
But on the flip side, if that 5% ends up gaining enough to become 10%, 15%, 25% or more, would that make a difference? Of course it would.”
Practicing proper risk management and allocation can make a world of difference in your portfolio. And greatly improve your performance as an investor.
So I would encourage you to think of speculating in terms of the risk standpoint first. What percentage will make it so that even if you lost all of your bets, it wouldn't hurt you?
Risk first. Returns later.
Regards,
Editor, Strategic Trader