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Knock-out warrants: low volatility impact

Suitable for speculation or hedging, this product type enables a leverage effect compared to its underlying product with a low capital outlay. The risk of total loss is limited to the capital outlay.

Knock-out warrants are categorised as leveraged products. They have some special features compared with traditional call and put warrants, including the incorporation of a barrier. As soon as this barrier is reached or breached, the knock-out warrants expire without value. A barrier is set below the underlying product’s current price in the case of knock-out call warrants (down-and-out call) and above the current price in the case of knock-out put warrants (up-and-out put). The integrated knock-out barrier means that knock-out warrants offer significantly better value for money compared to warrants with the same term and strike. However, there is a risk over the entire term that the barrier will be breached on the downside (knock-out call) or upside (knock-out put) and the warrant will expire immediately irrespective of its remaining term. They then either expire without value or a specific residual value is repaid, depending on the configuration of the product. Unlike warrants, these products benefit from a low volatility impact, making pricing easier for the investor to understand than in the case of warrants. Knock-out warrants also possess little or no time value and have a higher degree of leverage than similarly structured warrants. Due to their knock-out and higher leverage, they are riskier than comparable warrants.

Market expectations

Knock-out call or put warrants are suitable for investors who have clear positive or negative expectations regarding the price of the underlying product and who assume that the barrier will not be reached during the term or the intended holding period.

Investment universe and construction

Knock-out warrants are primarily issued for indices, currencies, commodities or equities (individual securities).

The product either has a term of just less than one year or an unlimited term (open-ended). The knock-out call warrant is effectively a securitised version of a down-and-out call option, while the knock-out put warrant is equivalent to a securitised up-and-out put option. The issuer of a knock-out warrant covers itself when selling this type of product by buying or selling the underlying product. The leverage effect means that the issuer has to invest significantly more capital than the investor to hedge the knock-out warrants sold. The issuer charges the investor for the interest costs incurred for this capital. When selling knock-out puts to investors, the issuer must sell underlying products in order to hedge its exposure. They receive capital from this which they can use to make interest-bearing investments. For that reason, it is not unusual for knock-out puts to trade with a negative premium (discount), in which case the instrument costs less than its intrinsic value. As interest costs for the issuer’s hedge or interest income are generated from a hedging position, the underlying price (financing level) is adjusted at regular intervals. As a result, the intrinsic value also changes accordingly. Interest costs, which can reach high single-digit percentages each year in some cases, are a central cost item that investors should take into account, as they influence any potential profits. This particularly affects underlying products with comparatively low volatility such as currencies or those that tend to move sideways over a longer period of time. In these cases, the interest costs incurred cause a significant decline in the instrument’s intrinsic value.

Common product types

Essentially, there are two types of knock-out warrants: those with and those without a stop-loss threshold. The version without a stop-loss threshold is more common. In this case, the exercise price and the knock-out threshold are identical. In the case of knock-out warrants with a stop-loss threshold, this threshold is above the exercise price (strike) for calls and below the exercise price for puts. Although the product matures early if this threshold is breached, a residual amount is generally paid out to the investor.

Scenarios

There are three typical scenarios: a rising price for the underlying product, a stagnating price, or a falling price. The first and third cases are ideal price trends for using a knock-out call warrant or a knock-out put warrant respectively. In the second case, rising interest costs in particular lead to an unfavourable result. The sharp fluctuations in the equity markets in the first few months of 2020 were perfect for knock-out warrants. Chart 1 shows the development of a knock-out call warrant and a knock-out put warrant on the Swiss Market Index (SMI) from the start of 2020 to mid-April. Chart 1: Knock-out call and put warrant on the Swiss Market Index. After a positive start until mid-February, the knock-out call warrant with an identical exercise price and knock-out threshold dramatically lost value due to the collapse in prices on the equity market caused by the coronavirus crisis, before rising sharply once again from mid-March as the first glimmers of hope began to emerge.

Chart 1 — Sources: Derivative Partners / Infront
Chart 2 — Sources: Derivative Partners / Infront

Chart 2 shows the impact of interest costs on a knock-out put warrant for the USD/CHF exchange rate. The only slight weakening of the USD against the CHF was not enough to offset interest costs. The intrinsic value of the knock-out put warrant fell well below its starting price despite moderate price gains. In the example shown in Chart 2, a knock-out put warrant with an original financing level of 1.15 as of the issue date lost more than 36% of its value between the end of October 2018 and 13 April 2020 due to high financing costs and the resulting steadily decline in the knock-out level, while the US dollar weakened by 3.50% against the CHF over the same period. Although the underlying product moved in the right direction, it did not weaken enough to compensate for the interest costs.

Development during the term

The value of a knock-out warrant reacts more strongly in percentage terms than that of the underlying product. This means that the nearer the underlying product’s price gets to the knock-out threshold, the greater the leverage effect. Unlike conventional warrants, knock-out warrants with a knock-out are only marginally influenced by volatility or the time value. They are generally already in the money when they are issued, with a delta close to one. While a decrease in the volatility of the underlying product reduces the risk of a barrier breach, the opportunity to generate higher profits also falls at the same time.

Source: Derivative Partners

Tips

When buying a knock-out warrant, it is essential for investors to make sure that there is sufficient distance to the knock-out threshold in order to avoid any unpleasant surprises. It is advisable to set stop-loss limits when buying and selling products. This way, products that move dangerously close to the barrier can be sold off early. Monitoring market developments closely is also important. Investors should exercise caution for products with significant leverage as they carry greater risk. The greater the leverage effect of a knock-out product, the greater the potential and risk of the instrument. If knock-out warrants trade close to the knock-out level, it is possible that issuers may significantly widen their spreads.

Valuation metrics

Distance of underlying product to knock-out (in %): the shorter the distance, the higher the risk of a breach and thus a total loss.

Gearing: Gearing shows how many knock-out warrants (adjusted for the ratio) can be bought for the price of the underlying product. With a delta of one, the gearing corresponds exactly to the effective leverage. Although the leverage effect offers the investor significant opportunities, it also carries a high level of risk, as leverage works in both directions. The leverage effect of knock-out warrants is calculated as follows: (price of underlying product x multiplier) / price of knock-out.

Intrinsic value: The intrinsic value of a knock-out warrant is typically not too far removed from the price of the certificate. It can be calculated as the difference between the price of the underlying product and the knock-out level, divided by the ratio.

Summary

Knock-out warrants should be used by experienced investors, primarily with a short to medium-term time horizon. The appeal of this product type lies in its leverage effect with reduced capital outlay. Furthermore, there is often the opportunity to choose between limited and unlimited terms. Another plus point is the high degree of price transparency and the low impact of volatility. This makes knock-out warrants highly suitable for hedging purposes, not least thanks to their daily tradability. On the other hand, buyers of knock-out warrants must be aware that they can suffer high losses if the underlying product moves in the wrong direction. In the worst-case scenario, this could lead to a total loss. Regular monitoring is therefore necessary when using this product type. Last but not least, knock-out warrants, like all structured products, are subject to issuer risk. However, they offer risk-conscious and risk-tolerant investors opportunities to generate exceptional income.

DISCLAIMER

The content of this article (including market commentary, market data and observations) is not a work product of any research department of Swissquote or its affiliates. This material is intended to highlight market action and does not constitute investment, legal or tax advice.

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Stefano Gianti

Stefano Gianti

Education Manager at Swissquote, Member of SIAT_Italia (the Italian Society of Technical Analysts) and IFTA (International Federation of Technical Analysts).