What are warrants?
Warrants are securities that can provide significantly higher returns than, for example, traditional stock investments. If you have a view on how a particular underlying security will perform, you can instead trade warrants linked to that security and get leverage in your investment.
Leverage
The leverage effect is made possible by the fact that when trading warrants, a smaller capital investment is required than if you were to buy the underlying security directly. For example, you can enjoy the same return as the underlying security by investing a smaller amount.
How do warrants work?
A warrant can be divided into the following parts:
- Underlying asset
- Type of warrant
- Exercise price
- Expiration date
Underlying asset
The development of a warrant is linked to the development of an underlying asset. Examples of underlying assets are stock indices or individual stocks.
Type of warrant
If you believe that the price will go up in the underlying asset, you can make money by buying a call warrant. If you believe that the price will go down in the underlying asset, you can make money by buying a put warrant. A call warrant increases in value when the price of the underlying asset increases, and a put warrant increases in value when the price of the underlying asset decreases. This means that you can get a return regardless of market developments, provided you are correct in your market belief.
Exercise price
The exercise price specifies the price at which you can buy the underlying asset on the expiration date. For a call warrant, if the underlying asset has a higher value than the exercise price on the expiration date, your call warrant has value, otherwise it does not. For a put warrant, if the underlying asset has a lower value than the exercise price on the expiration date, your put warrant has value, otherwise it does not.
Expiration date
Warrants have a limited term specified by their expiration date. After the expiration date, the warrant ceases to exist, and any value is paid out by the issuer to the holder.
Parity & multiplier
It usually takes several warrants to control the underlying asset. This is called parity or multiplier. If you buy a warrant that has a stock as an underlying asset and has a parity of 10, it means that you need 10 warrants to control 1 share. Some use the term multiplier instead to describe the same thing. The multiplier instead describes how much of the underlying asset each warrant controls. In the example, the multiplier would be 0.1, i.e., the equivalent of 1/10 share.
Cash settlement
It usually requires several warrants to control the underlying asset. This is called parity or multiplier. If you buy a warrant that has a stock as the underlying asset and has a parity of 10, it means that you need 10 warrants to control 1 stock. Some use the term multiplier instead to describe the same thing. The multiplier instead describes how much of the underlying asset each warrant controls. In the example, the multiplier would be 0.1, i.e. equivalent to 1/10 of a stock.
The value of the warrant on the expiration date
A call warrant will have a value on the expiration date if the price of the underlying asset is higher than the strike price of the warrant, otherwise not. The value will then correspond to the price of the underlying asset minus the strike price. A put warrant will have a value on the expiration date if the price of the underlying asset is lower than the strike price of the warrant, otherwise not. The value will then correspond to the strike price minus the price of the underlying asset. Keep in mind that warrants are traded as parts of the underlying asset and are stated as parity and must be included in the pricing of an individual warrant:
- Buy warrant = (Closing price - Strike price) / Parity
- Sell warrant = (Strike price - Closing price) / Parity
Warrant value during the term
Throughout the warrant's term, the issuer offers investors the opportunity to sell the warrant back to the issuer on the exchange. The value of the warrant during the term can be divided into two parts - intrinsic value and time value. The intrinsic value corresponds to the value the warrant would have if the expiration date were today. The time value can be described as the issuer's assumption of the probability that the warrant will have an intrinsic value on the expiration date. The likelihood of this depends largely on how much the price of the underlying asset is expected to move. Issuers estimate this probability differently, which can lead to different issuers having different prices on similar warrants.
Theoretical valuation
There are different models for calculating the value of a warrant during its term. Perhaps the most common model was developed by two mathematicians, Fischer Black and Myron Scholes. The model is called Black & Scholes, and the creators received the Nobel Prize in Economics for it in 1997. The model calculates a theoretical value of an option during its term based on five parameters: Underlying price, Term, Exercise price, Risk-free rate, and the underlying asset's future expected price fluctuation.
What risk does trading warrants entail?
Trading warrants involves high but limited risk. The leverage effect works both ways, and you can lose your entire invested capital, but never more.
How do I trade warrants?
You can trade warrants with your bank or broker.