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The universe of warrants has its own jargons. Make sure that you understand these jargons before choosing a warrant.

What warrant jargons should I know? What do they mean?

A call or put warrant is regarded as in-the-money, out-of-the-money or at-the-money depending on the following circumstances:

  Call warrant Put warrant
Underlying price > Exercise price In-the-money Out-of-the-money
Underlying price < Exercise price Out-of-the-money In-the-money
Underlying price = Exercise price At-the-money At-the-money

 

Intrinsic value: The difference between the underlying asset price and the exercise price of a warrant. Only in-the-money warrants have positive intrinsic value. Both out-of-the-money and at-the-money warrants have zero intrinsic value. The following table illustrates the intrinsic value of a call or put warrant in different scenarios.

  Intrinsic value
  Call warrant Put warrant
Underlying price (PU) > Exercise price (PE) PU - PE 0
Underlying price (PU) < Exercise price (PE) 0 PE - PU
Underlying price (PU) = Exercise price (PE) 0 0

Time value: The amount the warrant price exceeds the intrinsic value:

Time value = (Warrant price x Conversion ratio) - Intrinsic value

The following hypothetical example illustrates the calculation of the time value of call warrant A and put warrant B on the same underlying asset with a price of $8:

  Call warrant A Put warrant B
Exercise price $9 $8.5
Warrant price $1 $0.21
Conversion ratio 1 10
Intrinsic value $0 (∵ PU < PE) $0.5 (= $8.5 - $8)
Time value $1 (= $1 x 1 - $0) $1.6 [=($0.21 x 10)-$0.5]

For both out-of-the-money and at-the-money warrants, the warrant price is equal to the time value because the intrinsic value for each is zero. The time value of a warrant will decay over time and fall to zero on expiration.

Premium: Usually expressed as a percentage, indicates how much extra an investor is paying to buy the warrant instead of buying or selling the underlying asset directly:

Premium for a call warrant = {[(Exercise Price + (Warrant Price x Conversion Ratio)) / Underlying Price] - 1} x 100%

Premium for a put warrant = {1 - [(Exercise Price - (Warrant Price x Conversion Ratio)) / Underlying Price]} x 100%

Therefore, for the above example,

Premium for call warrant A = {[($9 + ($1 x 1)) / 8] - 1} x 100% = 25%

Premium for put warrant B = {1 - [($8.5 - ($0.21 x 10)) / 8]} x 100% = 20%

However, the premium does not tell you whether a warrant is expensive or inexpensive. Whether a warrant is expensive or inexpensive depends on its "implied volatility" (see below).

Delta: Measures the expected change in the theoretical warrant price with respect to a change in underlying asset price. Call warrants have positive delta, while put warrants have negative delta.

Delta = Change in (Warrant price x Conversion ratio) / Change in Underlying price

For example, suppose call warrant A and put warrant B have a delta value of 0.45 and -0.6 respectively. That means for every $1 increase (decrease) in the underlying asset price, theoretically, the price of call warrant A is expected to rise (drop) by $0.45, while the price of put warrant B is expected to drop (rise) by $0.6.

Delta is an important parameter for conducting hedging activities. When hedging, remember that the delta value may change as the underlying asset price changes.

Gearing: Simple gearing measures how many times the underlying asset costs more than the warrant you buy by comparing the value of the underlying asset to that of the warrant:

Simple gearing = Underlying price / (Warrant price x Conversion ratio), thus

Simple gearing for call warrant A = $8 / ($1 x 1) = 8 times

Simple gearing for put warrant B = $8 / ($0.21 x 10) = 3.8 times

That means you pay only $1 for call warrant A to participate in the price movement of an underlying asset which costs $8, or 8 times more. Similarly, you pay $2.1 for 10 units of put warrant B to gain exposure to the underlying asset, which costs $8, or 3.8 times.

Effective gearing measures the expected rate of change in the theoretical warrant price with respect to a 1% change in the underlying asset price:

Effective gearing = Simple gearing x Delta, thus

Effective gearing of call warrant A = 8 x 0.45 = 3.6

Effective gearing of put warrant B = 3.8 x -0.6 = -2.28

That means that for every 1% movement in the underlying asset price, theoretically, the price of call warrant A is expected to move by 3.6% in the same direction, while the price of put warrant B is expected to move by 2.28% in the opposite direction.

Gearing works both ways. Although higher gearing may give you higher returns, it also exposes you to higher downside risk. Also keep in mind that the level of gearing may change as the underlying asset price changes.

Implied volatility: A very important parameter for evaluating whether a warrant is expensive or inexpensive, similar to the P/E ratio used in rating a stock. As mentioned earlier, the expected volatility of the underlying asset price is among the five factors affecting warrant price. Assuming other factors remain unchanged, the higher the volatility, the higher the warrant price. It is then possible to work backwards through a certain option pricing model to calculate a figure for volatility implied by the market price of the warrant, i.e. implied volatility.

To evaluate whether a stock is expensive or not, we usually use its P/E ratio as a quick reference, not its share price. Similarly, to assess whether a warrant is expensive, we use implied volatility, not warrant price and premium. This is because the warrant price and premium are determined by a number of factors, such as the exercise price and time to expiry. For warrants on the same underlying asset, the higher the implied volatility, the more expensive the warrant.

That said, while choosing a warrant with an attractive price is important, make sure the warrant you select matches your investment strategy. Also, selecting a warrant with a "reasonable" rather than a "cheap" price is most important. Always remember to exercise your own judgement: Is a higher implied volatility reasonable? Is a cheap warrant really worth buying?