What are warrants?
A warrant gives the holder the opportunity to buy or sell a share at a future date for a fixed price. The two basic types of Warrants are "Call Warrants" and "Put Warrants". Call Warrants allow investors to profit from share price rises. Put Warrants allow investors to profit from share price falls.
A Call Warrant gives the holder the right, but not the obligation, to buy the underlying share for a fixed price known as the "exercise price" at a future date. Taking up this right is know as "exercising" the warrant.
A Put Warrant gives the holder the right, but not the obligation, to sell the underlying share to the Warrant Issuer for the exercise price (also known as "exercising" the warrant. )
NOTE: This is a hypothetical example.
- The graph shows the percentage change in the value of a hypothetical share compared with the value change in a call warrant and a put warrant. It illustrates the increased exposure to share price movements which warrants provide.
- During a 100 day investment period, the underlying share price falls by 10% (at Point A) and increases by 8% (at Point B).
- The share price varies over an 18% range during the investment period. In contrast, the call warrant fluctuates within approximately a 75% range of the purchase price.
- The put warrant also fluctuates within approximately an 80% range during the investment period but in an opposite direction to the call warrant.
Exercise price
The agreed price is known as the exercise price. This is the price at which a warrant holder may buy or sell the underlying shares.
A call warrant is said to be out-of-the-money when the exercise price is higher than the share price and in-the-money when the exercise price is lower than the share price.
A call warrant will be worthless if the share price is lower than the exercise price on the expiry day. However, with upward movements in the share price, the holder can still earn excellent returns trading the warrant prior to the expiry date.
The opposite occurs for a put warrant. It will be in-the-money when the exercise price is above the share price and out-of-the-money when the exercise price is below the share price. With downward movements in the share price, the holder can make profits trading the put warrant prior to its expiry date.
A call warrant is said to be out-of-the-money when the exercise price is higher than the share price and in-the-money when the exercise price is lower than the share price.
A call warrant will be worthless if the share price is lower than the exercise price on the expiry day. However, with upward movements in the share price, the holder can still earn excellent returns trading the warrant prior to the expiry date.
The opposite occurs for a put warrant. It will be in-the-money when the exercise price is above the share price and out-of-the-money when the exercise price is below the share price. With downward movements in the share price, the holder can make profits trading the put warrant prior to its expiry date.
Exercise style and expiry date
There are two styles of exercise for warrants - American and European. An American style warrant allows holders to exercise their warrants at any time up to and including their expiry date.
European style warrants allow conversion only on the expiry date.
Investors should also note the conversion ratio of a warrant. This is important in determining the quantity of warrants needed to be exercised to buy or sell one underlying share.
Warrants may sometimes be Cash Settled. They are usually European in style (that is they may not be exercised prior to expiry) and investors are given a cash amount equivalent to the amount the warrant expired "in-the-money." If for example a given warrant had a strike price of $10.00 and the stock price at expiry was $12.00 then the investor would receive $2.00 per warrant (assuming the conversion ratio was 1:1).
European style warrants allow conversion only on the expiry date.
Investors should also note the conversion ratio of a warrant. This is important in determining the quantity of warrants needed to be exercised to buy or sell one underlying share.
Warrants may sometimes be Cash Settled. They are usually European in style (that is they may not be exercised prior to expiry) and investors are given a cash amount equivalent to the amount the warrant expired "in-the-money." If for example a given warrant had a strike price of $10.00 and the stock price at expiry was $12.00 then the investor would receive $2.00 per warrant (assuming the conversion ratio was 1:1).
Why Trade Warrants
Gearing
Warrants cost only a fraction of the price of shares. However, they can provide investors with greater exposure to share price movements as their prices generally rise and fall more steeply than shares in percentage terms. This increased exposure can subsequently offer greater potential profit as a percentage of the capital invested.
Conversely warrants also expose investors to greater potential loss in percentage terms. However, you are never obliged to pay anything more than the initial price of the warrant, so the maximum amount you can lose is limited to the price paid.
Unlimited upside & limited downside
Although warrants can potentially multiply both gains and losses, investors can only ever lose the price of the warrant. Generally the cost of a warrant is significantly less than the price of the underlying share.
Low transaction costs
Trading Warrants typically costs less than trading the underlying shares. Currently no stamp duty is payable on the purchase or sale of cash settled Warrants and brokerage and interest costs are reduced because the price of Warrants is usually less than the underlying share price.
Ease of trade
Warrants are traded on the SEHK AMS3 system. The AMS3 system provides market transparency which allows stockbrokers to execute all trades quickly and effectively.
Insurance
Warrants can be used as a form of insurance to protect an existing share portfolio against a falling market. An investor with a holding in a particular stock who was nervous about the future direction the market could purchase put warrants instead of selling shares. This would allow the investor to retain share ownership without realising capital gains and without having full exposure to the downside risks.
Hedging
Releasing Share Capital
Call Warrants can also be used to free up capital invested in shares. An investor may sell existing share holdings and purchase a corresponding number of Call Warrants for a fraction of the price. The investor has maintained exposure to share price rises while releasing capital from the security holding.
Selecting a Warrant
To select the warrant best suited to your investment goals, we advise you to consider the following process.
To choose a warrant you should first look at the nature and performance of the underlying shares. This will assist in enabling you to make an informed decision about the anticipated movement of the stock.
The next criteria will be your view (positive or negative) on the stock. This will determine whether you select a call warrant or a put warrant.
Your selection will be further narrowed by the time frame of your view. Remember that time decay may erode your profits.
The amount of gearing you are seeking is also relevant. The effective gearing of a warrant is determined by the delta the relationship between the share price and the warrant price and the gearing ratio. Effective gearing is expressed as a multiple. The higher the multiple, the higher your returns or losses would be.
When comparing different warrants over the same share, you should be aware that warrants with high volume turnovers will not necessarily deliver higher returns.
By gaining an understanding of how warrant issuers determine the value of warrants, investors should be in a better position to develop an appropriate trading strategy.
Pricing
The value of a warrant is influenced by the five market variables outlined in the table below. The arrows indicate which direction the value of call or put warrants will move in response to a change in the corresponding variable in most situations.
| Pricing Variables | |||
| Variable | Change in variable | Change in call warrant price | Change in put warrant price |
| Underlying share price |  | |  |
| Dividend expectations | | | |
| Volatility | | | |
| Interest rate | | | |
| Time to expiry | | | |
Share price
The underlying share price is the key driver of the warrant price. As the share price increases, the value of a call warrant should increase. Conversely, the value should fall as the share price falls.
The opposite occurs for put warrants. Put warrants should increase in value as the share price falls and decrease in value as the share price rises.
By successfully predicting the price direction of shares, investors can profit from trading warrants on positive and negative views.
By successfully predicting the price direction of shares, investors can profit from trading warrants on positive and negative views.
The tables below demonstrate the anticipated movements of a call warrant and a put warrant investment. In estimating the returns an assumption has been made that there will be a 10% increase and a 10% decrease in the share price at the end of a 3 month investment period.
Investor purchases 10,000 XYZ Macquarie Call Warrants for $1.00 each.
XYZ's share price is $10.00. | |||
| Price in 3 months | $9.00 | $10.00 | $11.00 |
| of Warrants | 10,000 | 10,000 | 10,000 |
| Price in 3 months | $0.40 | $0.85 | $1.50 |
| Price | $10,000 | $10,000 | $10,000 |
| Proceeds | $4,000 | $8,500 | $15,000 |
| on Call Warrant | (60)% | (15)% | 50% |
| on Share Investment | (10)% | 0% | 10% |
Clearly, when the share price increased, the warrant provided a better return than the underlying share. While the share price increased $1.00 (from $10.00 to $11.00), that is 10%, the call warrant increased $0.50 (from $1.00 to $1.50), providing a 50% return.
Note: When the share price remains constant at $10.00, the warrant price falls 15% (from $1.00 to $0.85) during the three month investment period. This is due to time decay.
Note: When the share price remains constant at $10.00, the warrant price falls 15% (from $1.00 to $0.85) during the three month investment period. This is due to time decay.
| Investor purchases 10,000 XYZ Macquarie Put Warrants for $1.00 each. XYZ's share price is $10.00. | |||
| Share Price in 3 months | $9.00 | $10.00 | $11.00 |
| Number of Warrants | 10,000 | 10,000 | 10,000 |
| Warrant Price in 3 months | $1.50 | $0.85 | $0.40 |
| Purchase Price | $10,000 | $10,000 | $10,000 |
| Sale Proceeds | $15,000 | $8,500 | $4,000 |
| Return on Put Warrant | 50% | (15)% | (60)% |
| Return on Share Investment | (10)% | 0% | 10% |
When the share price decreased $1.00 (from $10.00 to $9.00), the warrant provided a 50% return to the warrant holder while the share holder sustained a 10% loss. This illustrates how an investor can profit from share price falls by holding put warrants.
By gaining an understanding of how issuers determine the value of warrants, investors should be in a better position to develop an appropriate trading strategy.
By gaining an understanding of how issuers determine the value of warrants, investors should be in a better position to develop an appropriate trading strategy.
Delta
We have demonstrated that the direction of the warrant price is directly related to the direction of the underlying share price. Generally, warrants do not move cent for cent with the underlying shares. The relationship between the movement in the share price and the corresponding change in the warrant price is referred to as the delta.
A delta of 1 means that the value of the warrant should change one cent for every one cent change in the underlying share price. A delta of 1 also means the warrant is currently in-the-money and there is a 100% expectation that the warrant will expire in-the-money.
A delta of 0.5 means that there is only a 50% expectation that the warrant will expire in-the-money. Accordingly, it means that the value of the warrant should change by 0.5 cents for every one cent change in the underlying share price.
Deltas will change over time as the relationship between the Exercise Price and Share Price changes. Both delta and prices of warrants on this site are calculated on a daily basis.
While the delta is a useful measurement for investors wishing to track the daily movement of their warrants, it is also important to understand the principle of effective gearing.
A delta of 0.5 means that there is only a 50% expectation that the warrant will expire in-the-money. Accordingly, it means that the value of the warrant should change by 0.5 cents for every one cent change in the underlying share price.
Deltas will change over time as the relationship between the Exercise Price and Share Price changes. Both delta and prices of warrants on this site are calculated on a daily basis.
While the delta is a useful measurement for investors wishing to track the daily movement of their warrants, it is also important to understand the principle of effective gearing.
Effective gearing
One simple measure of gearing is to determine how many warrants can be purchased for the cost of one share. For example, if the share costs $20 and the warrant $2, then the gearing is 10. The effective gearing of a warrant provides a realistic expectation of how much the warrant should outperform or underperform the underlying shares over a short period of time. Effective gearing is calculated by dividing the share price by the warrant price and multiplying this by the delta.
| Effective Gearing | = | Share Price __ Warrant Price | X | Delta |
So it recognises that whilst you may be able to buy, say, 10 times as many warrants as shares, the warrants may not be moving cent for cent with the shares. For example, if the warrant used in the simple gearing example has a 50% delta, then the effective gearing is only 50% x 10 = 5.
An effective gearing multiple of 5 implies that every $1.00 invested in the warrant could equate to $5.00 invested in the underlying share.
Investors should be aware that the effective gearing multiple does change and therefore is only applicable for short periods of time.
An effective gearing multiple of 5 implies that every $1.00 invested in the warrant could equate to $5.00 invested in the underlying share.
Investors should be aware that the effective gearing multiple does change and therefore is only applicable for short periods of time.
Time to expiry
The greater the time to expiry, the greater the time value of the warrant. This is because the warrant has more time to perform or move into-the-money.
The time value of warrants can be expected to gradually decline in value to zero over the life of the warrants. This gradual decline in the time value is effectively part of the daily cost of holding a warrant.
The time value of warrants can be expected to gradually decline in value to zero over the life of the warrants. This gradual decline in the time value is effectively part of the daily cost of holding a warrant.
An alternative way of understanding time decay for warrants is to consider it as equivalent to the daily decay of an insurance policy. The policy falls in value each day it approaches its expiry date because the period of insurance is decreasing.
Similarly the opportunity for the warrant to move into-the-money is decreasing and therefore the warrant value will decrease. In our hypothetical examples, time decay is responsible for a 15 percent decrease in the warrant price when there is no change in the share price over the three month investment period. While the intrinsic value has remained unchanged, the time value has decreased to produce an overall decline in the warrant price.
Dividends
Investors in warrants do not receive the dividends paid on the underlying shares, nor or do they directly participate in rights or bonus issues.
However, in valuing warrants, issuers estimate the expected dividend stream of the underlying shares. This means that call warrants should not dramatically fall in price when the underlying share trades ex-dividend. Similarly, put warrants should not substantially increase in price. Generally, in the case of a rights or bonus issue, the terms of the warrant are adjusted so that the investor is not disadvantaged.
However, in valuing warrants, issuers estimate the expected dividend stream of the underlying shares. This means that call warrants should not dramatically fall in price when the underlying share trades ex-dividend. Similarly, put warrants should not substantially increase in price. Generally, in the case of a rights or bonus issue, the terms of the warrant are adjusted so that the investor is not disadvantaged.
Volatility
Volatility is a standard measure of risk on the underlying shares. Issuers will forecast the expected volatility of the share price for the life of the warrant. The higher the volatility, the higher the risk on the underlying shares and therefore the more expensive the warrant will become.
Interest Rates
For each call warrant issued, issuers allocate funds to purchase underlying shares. If the cost of borrowing (ie. the interest rate) increases, the cost will be reflected in a corresponding increase in the warrant price.
Similarly, a put warrant will decrease in value when interest rates rise.
Similarly, a put warrant will decrease in value when interest rates rise.
Warrants derive their value from another financial instrument such as shares, currency, an index or units in a unit trust. While returns from investing in warrants may outperform returns on shares, there are a number of additional factors determining warrant values, hence they are seen as more risky than trading ordinary shares.
