To the amateur investor, warrants may be a foreign-sounding instrument to you. If the only time you’ve heard of this term is when police have the authority to enter a house to make an arrest, you should totally read on.
Examine the screen you see the next time you load up your trading account. You would probably have noticed these weirdly-named tickers:
Ever wondered what those strings of letters and numbers are?
Contrary to popular belief, they do not shed light as to what combinations the next winning TOTO ticket will be.
These are a form of financial instruments called warrants. While they look like gibberish, there is a certain structure to their names.To obtain the full details before investing, one should always check with SGX’s website and search for the warrant.
1) What Are Stock Options and Warrant
A stock option is a contract to buy (Call) or sell (Put) a stock to the issuer at the Strike price on the Expiry date. A European-style contract means the contract can be Called or Put on Expiry only, while an American-style contract means it can be done any time before the Expiry. In reality investors do not usually exercise their Calls or Puts because they can exit the contract by selling the options back to the market.
In Singapore, the exchange does not offer stock options as a form of investment. Hence we have issuers such as Macquarie or UBS who issue structured warrants which behave in a similar manner to stock options.
For example, the fourth item in the picture above, HSI26000UBePW150828, means a European-style Put Warrant (ePW) on Hong Kong’s Hang Seng Index (HSI) for the right to sell the index at the strike price of 26,000 points, and this warrant is issued by UBS AG Bank (UB) expiring on 28 Aug 2015 (150828).
Well, this shortcut was definitely useful in packing a lot of information into one line.
The other form of warrants (i.e. Centurion W171028) is simply a company warrant which gives the holder the option to purchase company shares (i.e. Centurion) by the expiry date (i.e. 28 Oct 2015).
2) How Are Options and Warrants Traded
Stock options are securities where the seller (also known as the Writer) of the option gives the Buyer of the option the right to purchase (Call) or to sell (Put) stocks at an agreed price at an agreed upon date in future.
Options are usually written by an exchange or the company.Warrants are written by the company itself. Structured warrants are written by a third-party financial institution such as a warrant dealer. These are often traded on exchanges or online brokers.
An exception to this is employee stock options which are written by the company and usually not traded on the exchange, instead given to employees as a form of remuneration.Employee stock options offer employees an incentive to get them to invest in the company and for them to maintain vested interest in the organization.In most cases, stock options are usually available only to company staff.
In Singapore, structured warrants for most of the major stocks and stock indices are available for trading on the exchange.
3) Risk and Return
Purchasing structured warrants offer several benefits to investors. However, as with all investments, there are risks involved.
The biggest risk is that the warrant will expire worthless. That is the loss of the entire capital invested. As a warrant goes nearer to expiry date, its value will decrease to zero.
On the other hand, to compensate for the higher risk, stock warrants allows the investor to benefit from large gains during favourable market conditions. For example, if the underlying stock of a call option increases higher than the strike price, it will allow the investor to make a capital gain since the investor will be able to purchase those stocks at the agreed lower strike price. For a put option, the investor makes a gain if the underlying stock decreases below the strike price.
The table above shows the gains from buying stock and warrants for different market prices. Note that while the warrants might expire worthless, gains are magnified many times if the market price of the underlying is above the strike price at expiry!
4) Common Strategies
For the average investor in Singapore, there are two common strategies to use structured warrants.
Speculate On Increase In Price In The Near Term
If an investor expects the stock (or underlying security) price to rise to $55 from $45 in the near term (i.e. next 6 months), a call warrant may be purchased with a 6 month expiry. To lower the cost of the warrant, a high strike price can be purchased (i.e. $50) because the value of the option would be very low at the beginning, allowing more units of warrant to be purchased. In finance jargon this is also known as buying “out-of-the-money”.
The risk is of course where the price doesn’t rise above $50 before expiry. In that case the warrant will expire worthless.
If an investor already owns the stock (or underlying security) at say $50 but wants to protect against any short-term decrease in value, put warrants may be purchased with a strike price at $50. Hence any decrease in the stock price will be offset by the gains from the put warrants!
However this strategy would require replacing put warrants once they expire, assuming the investor wants to continue the “portfolio insurance”. In the long term this drags down on overall profits due to the cost of purchase.
Cheaper put warrants can be purchased if lower strike prices are purchased (i.e. $45) but this reduces the protection offered.
Also the payoff of the protection should be calculated before deciding on how many units of warrants to purchase. This is because the gains from warrants are usually magnified compared to the underlying stock. In other words, the amount of warrants required to protect a stock position is usually lower than the number of stock held.
5) Cashing In on Warrants
While there is an expiry date, to cash in the speculation gains, all the investor has to do is to sell the warrants before the expiry.
For the protective put strategy, the investor could exit a losing stock position by selling his shares and offset the losses by selling off the put warrants which is likely to be showing a gain due to the fall in share prices. Again, this only works before the expiry date.
In summary, derivatives such as options and warrants allow investors to benefit from volatility and allows investors to speculate or to protect current stock positions. The key is to always weigh the costs and benefits by analysing the possible payoffs before purchasing the warrants.
[feature image credits: veracityfinancialservices.com]