Editor’s note: This article was first published in September 2010. The Telefonica and Repsol prices and the Repsol warrants expiring on 16 March 2007 are illustrative figures from 2007-2010; the warrant market and the products banks offer have changed since.
Continuing with investment models and investment vehicles, today we’re looking at the possibility of investing in warrants. Since we assume this is an investment vehicle many investors don’t know, we’ll start by explaining what warrants are.
What is a warrant?
A warrant gives its holder the right, but not the obligation, to buy (CALL) or sell (PUT) a set number of securities on an asset (the underlying), at a set price (the exercise price or strike), on a date fixed in advance (expiry). A warrant is therefore a contract with a fixed term.
A call warrant on Telefónica with a strike of 14 euros, a purchase premium (ask price) of 1 euro and a 12-month expiry means you are paying 1 euro for the right, but not the obligation, to buy Telefónica at 14 euros within 12 months. Whenever the share trades above the exercise price (also called the strike) plus the premium paid for that right, you will be willing to exercise that option (right) and acquire the share at the warrant’s exercise price or strike.
In the case of a put warrant on Telefónica with a strike of 13 euros, a purchase premium (ask price) of 1.05 euros and a 12-month expiry, you are paying 1.05 euros for the right, but not the obligation, to sell Telefónica at 13 euros within 12 months. Whenever the share trades below the exercise price minus the premium paid, you will be willing to exercise that option and sell the share at the warrant’s exercise price or strike.
How to invest in warrants
Warrants are bought and sold on the stock exchange, just like shares. To buy or sell a warrant, all you need to do is contact your broker or financial intermediary. As a rule, your bank’s investment platform will let you buy this product.
The possible underlying assets of a warrant include:
- Shares
- Baskets of shares
- Stock market indices
- Interest rates
- Currencies
- Commodities or commodity indices
In principle, any asset traded on an organized market can be the underlying of a warrant. Warrants on shares make it possible to take positions on a specific company. Warrants on baskets of shares let you take a position on the performance of a particular sector or group of shares with a single instrument.
Warrants on indices give you the chance to take a position on a given index with a small investment and the benefit of leverage. As with other warrants, you can pursue different strategies, from hedging a share portfolio that replicates the index to taking a bullish or bearish position on the benchmark index. In the case of indices, warrants can be referenced either to the spot index or to the futures contract on that index.
Types of warrant (CALL or PUT)
A CALL warrant gives its holder the right, but not the obligation, to buy a set number of securities on an asset (the underlying), at an established price (the exercise price or strike), on a date fixed in advance (the expiry date).
| Underlying | Type | Strike | Expiry | Ratio | Premium |
|---|---|---|---|---|---|
| REPSOL | CALL | 26 € | 16 Mar 2007 | 1/1 | 0.76 – 0.77 € |
In the table above, by definition, the Repsol 26 € CALL gives its holder the right to buy one Repsol share at 26 euros, from the moment of purchase until 16 March 2007. The investor has to pay 0.77 euros to acquire the warrant.
Whether Repsol trades at 25 € or 27 € will determine the premium (the price) of the warrant.
- If Repsol trades at 27 €, the possibility of buying (owning) the share at 26 € through the warrant is attractive, since you could (you have the right, not the obligation) acquire the share at a lower price than its market price. Because the option is attractive, the warrant’s premium is high.
- If Repsol trades at 25 €, the possibility of buying (owning) the share at 26 € through the warrant is no longer so attractive, since you would be acquiring the share at a higher price than the market, which is not in your interest. The premium is lower.
In this way, you can see how the price movement of the underlying asset will make the warrant’s premium higher or lower, for both CALLs and PUTs.
Note that the warrant’s premium consists of two prices, 0.76 – 0.77 euros, corresponding to the bid and offer sides (just as with shares).
An investor who buys the warrant will pay 0.77 euros, the ASK price, while one who wants to sell it will receive 0.76 euros, the BID price.
If an investor buys shares in a stock X trading at 26 euros, their expectation is obviously bullish. However, if the price moved the other way and the stock lost, say, 30% of its value, the investor would lose 7.80 euros on each share bought.
If, instead, the investor buys a CALL warrant on stock X for 0.77 euros, they can still profit from the rise in the underlying if it goes up; but if the share price falls 30%, losses will always be limited, at most, to the premium paid for the warrant, that is, 0.77 euros per right to buy the stock.
In any case, Société Générale recommends not holding warrants until expiry, since they are liquid products that allow active trading and, thanks to leverage, let you make attractive gains by applying investment strategies in the market.
Buying a PUT warrant
A PUT warrant gives its holder the right, but not the obligation, to sell a set number of securities on an asset (the underlying), at an established price (the exercise price or strike), on a date fixed in advance (the expiry date).
| Underlying | Type | Strike | Expiry | Ratio | Premium |
|---|---|---|---|---|---|
| REPSOL | PUT | 25 € | 16 Mar 2007 | 1/1 | 0.57 – 0.58 € |
As the example shows, by definition, the Repsol 25 € PUT gives its holder the right to sell one Repsol share at 25 euros, from the moment of purchase until 16 March 2007. The investor has to pay 0.58 euros to acquire the warrant; in other words, the investment is 0.58 €.
As in the CALL example, whether Repsol trades at 24 € or 26 € will determine the premium (the price) of the warrant.
- If Repsol traded at 24 €, the possibility of selling the share at 25 € through the warrant is attractive, since we could (we have the right, not the obligation) sell the share (a theoretical right; you don’t need to hold the shares in your portfolio) at a higher price than its market price. The option is attractive, so the warrant’s premium will be high.
- If Repsol traded at 26 €, the possibility of selling the share at 25 € through the right the warrant confers would no longer be so attractive, since the share is trading at a higher price. The premium would be lower.
Note that the warrant’s premium consists of two prices, 0.57 – 0.58 euros, corresponding to the bid and offer sides (just as with shares). An investor who buys the warrant will pay 0.58 euros, the ASK price, while one who wants to sell it will receive 0.57 euros, the BID price.
Warrants also make it possible to boost your investment capacity when the market is falling, when prices go down.
One way to profit from stock market falls is to sell securities short, that is, to borrow shares in order to sell them and buy them back at a lower price. The risk of this strategy is that if the stock doesn’t fall, you are exposed to unlimited losses, because the borrowed shares must be “returned”, and the higher the price rises, the bigger the losses. In addition, this kind of strategy carries an extra cost: interest charged on the market value of the shares sold.
If, on the other hand, you think an asset is going to fall and you buy PUT warrants on it, you will benefit from the warrants’ leverage if the asset falls, while if the underlying rises instead, your loss will be limited to the premium paid.
Further reading
- Why the stock market is the most profitable investment
- The most common mistakes stock market investors make
- How to invest in the US stock market
- What Arthur Rock analyzes before investing
Featured image: Benjamín Núñez González, CC BY-SA 4.0, via Wikimedia Commons.
