Warrants: episode 2
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If you understood the concept of an option, you should be able to quickly get to grips with warrants — at least if, like me, you were asked to explain them. All you’d need to do is reread the definition of an option, make a few technical and administrative adjustments, and there you go: job done!
Here, then, is a crude definition of a warrant:
Well yes, I know, it’s not the easiest thing to read. But if you learn it by heart and repeat it like a mantra every evening before going to bed, you should be able to build it into your psychology as a trader. It doesn’t mean that you will know how to use it, but you will at least be able to wow others by dropping it into conversation.
A warrant is a financial instrument that entitles its holders to buy (this is a «call warrant») or sell (a «put warrant») a financial asset (known as the «underlying») at a price (the «exercise price» or «strike price») before (or on) a pre-determined expiry date.
I did warn you: this is not light reading. What you need to remember, however, is that the principle is identical to an option. Warrants can be issued over almost anything you like: shares, indices, currencies, commodities or interest rates, but it should be remembered that certain underlying assets are much more volatile than others. You can imagine the swings that are seen on certain commodities. (A friendly mention of everyone’s favorite: oil…). The exercise price is the price at which the underlying may be bought or sold on the warranty’s expiry date (if the warrant is a European warrant), or at any time (if the warrant’s issue terms state that it is an American warrant).
There are no rules on the term of a warrant. Listed options are governed by rules that restrict what can be done with them. Issuers themselves may, however, determine the terms and conditions of the warrants — given that warrants are issued on an independent basis. The terms of warrants range, in general, from a few months to several years.
What must be remembered is that investors who buy warrants predict the direction that the underlying is going to take and try to benefit from the product’s leverage to maximize their gains and, at the same time, control the risks associated with their portfolios.
The main differences between warrants and options
Firstly, options are traded on regulated markets, such as Eurex in Europe and the CBOE (Chicago Board Options Exchange) in the USA. These markets manage, regulate and determine the terms and conditions of options. There is no room for creativity: everything is very clear, straightforward and concise.
In contrast, warrants are what are known as transferable securities — just like shares. They are issued by financial institutions and the terms and conditions are at the complete discretion of the issuer. In terms of bank account entries, a warrant will appear on your statement in the same way as shares or bonds, but not options. An option is a futures contract.
Another specific feature: an option can be sold before it is purchased (a short call or short put), but short selling a warrant is strictly forbidden. You must have bought a warrant in order to be able to sell it. I know that seems logical, but the fantasy world of finance moved into another dimension long ago.
Welcome to the (more) complicated world of (structured) products. Let’s look at knock-out warrants
Let’s be honest — warrants were principally developed purely for speculative purposes. They allow people to make small investments with the hope of a significant gain, benefiting from the leverage provided by the product’s structure. But that wasn’t enough — because, in the words of Gordon Gekko, «greed is good» — so knock-out warrants were invented. This particular type of warrant is a highly leveraged product and is slightly different from a «traditional» warrant.
Unlike standard options and warrants, knock-out warrants may expire prematurely where the price of the underlying falls below a predetermined threshold (a «knock-out call») or exceeds that threshold (a «knock-out put»). Depending on the product’s structure, they may either become worthless or a residual value may be repaid to the investor.
Let’s put this in simple terms: broadly, a floor price is placed on a call warrant and if the price of the underlying falls below that floor, the knock-out is triggered and the warrant immediately expires. Let’s say that you have a knock-out call warrant over UBS shares with a strike price of 12 and a floor price of 9. If the price of UBS shares falls to CHF 9 before expiry, your knock-out warrant will expire immediately. The risk is therefore huge, but the benefit is that, if you’re right, and the share price rises to 15 within 6 months and never falls back to 9, your gains will be impressive! But as in ANY extremely profitable transaction, the risk is immense, since the capital you have invested may go up in smoke in the space of a second. This example uses knock-out calls, but the principle is the same for puts.
In graphical form, the difference between warrants with or without knock-out can be shown as follows:
The effect of the knock-out, which makes the product worthless once the threshold is breached, is clear to see. The two main « enemies » of the purchaser are therefore the threshold and time.
Checklist before taking the plunge
Premium
The issuers of a product, generally banks, build into the price the fact that they must either buy or sell the underlying. They do that for one simple reason: so that they are not speculating against their clients, but also because new banking regulations do not allow them to use the bank’s capital as they might have done in the past.
Also, as the products are significantly leveraged, a substantial capital commitment is made by issuers and, since nothing comes for free, issuers charge for this investment. Why? Because all commitments involve interest on capital, in other words, the premium.
Where knock-out puts are sold to investors, issuers must sell the underlying assets to cover their position. They thereby obtain capital on which they may earn interest, where interest is available. As such, it is not uncommon for knock-out puts to be traded at a discount.
It is therefore important to check the terms and conditions and compare the product with similar existing products before making your choice. The rules of the market are what they are, and sometimes certain issuers are not shy about the level of their premium charges.
Leverage
Like options and warrants, these products entail a significant degree of leverage. The greater a knock-out product’s leverage, the greater the chances that the security will generate a gain, but also the greater the risks of incurring a loss. Investors therefore need to be aware of the current difference between the price of the underlying and the threshold(s). A sufficient gap is required, but, most of all, investors need to be aware of the risks associated with buying such a product. It cannot be repeated enough: the risk is that you will LOSE EVERYTHING, often at unprecedented speed. This is one of the basic lessons of investing: the higher the risks, the higher the potential returns. In summary, if you want to make large gains in very quick time, you need to accept the risk of losing everything, also in very quick time.
Calculating the intrinsic value
The intrinsic value of a knock-out warrant is calculated as follows:
(price of the underlying x exercise ratio) / knock-out price
Again, in the case of warrants, the human imagination has no limits. Generally, investors or speculators buy a put or call (option or warrant) to benefit from a rise or fall in the price of an underlying.
You learnt that, in the case of a knock-out, the strategy ends with the investment being lost when a threshold (either a cap or a floor) is breached. But, of course, issuers of products worked out that they could add an additional threshold. This is known as a «double lockout». Products with a double lockout include thresholds above and below the market value of the underlying.
If, therefore, the value remains within these two thresholds, investors receive a predetermined amount on expiry. Of course, if either of the thresholds is breached, investors lose their initial investment. If the price of the underlying moves very little between the two thresholds, the investor will be sitting pretty. If, however, the price of the underlying fluctuates significantly between the two limits (i.e. the volatility increases), the warrant’s price falls.
The most important thing to remember is that there is a huge range of possible strategies using warrants. By adding conditions, thresholds or coupons, you move from traditional warrants to structured products that are currently very fashionable.
Term sheet
Your best friend when purchasing a warrant is ALWAYS the term sheet, a list of all the information and all terms and conditions relating to issue of the product. The Swiss Structured Products Association (SSPA) requires certain minimum information to be included in a term sheet, including the product’s categorization. This information allows you to compare the product with similar products issued by competitors, and lets you know what to expect.
Does the casino always win? How?
Issuers of warrants do not “play” against investors. The prices of products are calculated using formulas, such as the Black and Scholes model. Issuing banks are working in a competitive environment and therefore have an interest in offering a better price than that offered by a different bank. If they do not, arbitrageurs will do it for them.
Issuing banks make money through the spread, i.e. the difference between the purchase price and sale price of their warrants. The main driver of growth in their revenue is, put very simply, trading volumes, together with a large catalog of products to attract regular customers. Or traders.
Conclusion
The complexity of leveraged products varies. Knock-out warrants involve a number of subtleties that investors should understand before investing in this market. Investors should, among other things, understand how these products are valued and the different factors affecting their market prices.
Investors and speculators obviously need to have clear objectives and be aware that they risk losing all or part of their investment. They might, however, be able to use leverage to either protect a portfolio or speculate.
Are you ready to put your knowledge into practice? Via its Swiss DOTS platform, Swissquote offers a large range of leveraged products over various base securities, such as international and Swiss equities, currency pairs, indices and precious metals. The wonderful world of warrants awaits you.
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