ABC of warrants
Basics of Warrants
Warrants are a popular investment product in Hong Kong. However, to some retail investors, there is a misconception that warrants are just like stocks. They fail to realise that warrants, as derivatives, are more complicated than stocks in nature.
So, what are warrants?
Warrants are an instrument which gives investors the right - but not the obligation - to buy or sell the underlying asset (e.g. a stock) at a pre-set price on or before a specified date.
I only need to know which company a share represents. What else should I know about warrants?
Compared with stocks, warrants have more attributes which include:
- Issuer: A warrant can be issued by a listed company (i.e. subscription warrant) or a third party such as a financial institution (i.e. derivative warrant).
- Underlying asset: It can be a single stock, a basket of stocks, an index, a currency, a commodity, a futures contract (e.g. oil futures) etc.
- Types of embedded rights: Don't mix up a call warrant with a put warrant. A call warrant gives you the right to buy whereas a put warrant gives you the right to sell the underlying asset.
- Exercise price: The price at which you buy or sell the underlying asset in exercising a warrant.
- Conversion ratio: This refers to the number of units of the underlying asset exchanged when exercising a unit of a warrant. Normally, in Hong Kong a derivative warrant on shares has the ratio of 1 (i.e.one warrant for one share) or 10 (i.e.10 warrants for one share).
- Expiry date: The date on which a warrant will expire and become worthless if the warrant is not exercised.
- Exercise style: With an American warrant, you can exercise to buy/sell the underlying asset on or before the expiry date. Whereas a European warrant allows exercise on the expiry date only.
- Settlement: A warrant can be settled by cash or physical delivery upon exercise.
Some warrants have more sophisticated features and are generally referred to as exotic warrants.
Are there any examples?
Suppose there are two warrants, A and B, which have the same underlying stock C and an exercise price of $1:
|Warrant name||Warrant type||Conversion ratio||Expiry date||Exercise style||Settlement|
|A||Call||10||5 July 2006||American||Physical|
|B||Put||1||8 May 2006||European||Cash|
Warrant A gives you the right to buy one share of stock C at $1 for every 10 warrants you hold on or before 5 July 2006. If you exercise the warrant, you will receive physical shares of stock C.
On the other hand, warrant B gives you the right to sell one share of stock C at $1 for every one warrant you hold on 8 May 2006. If you exercise the warrant, you may receive either a cash amount or nothing depending on the level of the underlying share price around the expiry date.
There are so many warrants available in the market. How can I distinguish them?
There are two main types of warrants: subscription warrants and derivative warrants, which are subject to different provisions of the Listing Rules in Hong Kong.
Subscription warrants are issued by a listed company and give holders the rights to buy the underlying shares of the company. They are either attached to new shares sold in initial public offerings, or distributed together with declared dividends, bonus shares or rights issues. Subscription warrants are valid between 1 and 5 years. Upon exercise, the underlying company will issue new shares and deliver them to the warrant holders.
Derivative warrants are issued by financial institutions. Unlike subscription warrants which must be call warrants, derivative warrants can be call or put warrants. Most of the derivative warrants in the market have a shorter life, ranging from 6 months to 2 years normally, although the current Listing Rules allow a maximum life of 5 years.
Derivative warrants can be linked with a single stock, a basket of stocks, an index, a currency, a commodity or a futures contract (e.g. oil futures). They can be settled by cash or physical delivery, which must be specified by the issuers at launch. However, basket 1, index warrants and warrants on stocks listed overseas are settled by cash only.
In exercising a call derivative warrant on a single stock with physical settlement, the issuer will deliver the underlying shares to the warrant holder. This does not involve the issuance of new shares by the underlying listed company as in the case of subscription warrants.
Furthermore, every derivative warrant has a designated liquidity provider to help improve the liquidity of the instrument in the market. Such a requirement does not apply to subscription warrants.
What are the differences in trading warrants as compared with stocks, options and futures?
When you buy stocks, you become a shareholder, and have the right to vote at the general meetings and receive declared dividends and bonus shares. If you hold warrants, you normally do not have such rights. Besides, warrants have a restricted life, and once the exercise period lapses, they become worthless.
Conceptually, warrants are a special form of options. You can only take a long (buy) position in trading warrants. However, you can long or short (write) an options contract. Same as warrant holders, options buyers only face the risk of losing all the upfront capital invested if they let the options expire. Options writers, however, are more passive and must meet the obligations arising from buyers exercising the options. In return for the unlimited downside risk, writers are paid a premium by option holders.
If you trade futures, you still need to meet the obligations when the underlying asset price moves against your view. Theoretically, your losses are unlimited under that situation. Should you hold warrants, you can simply choose not to exercise and your loss will be limited to the amount of your original investment.
That's great. Shall I start trading warrants?
These are only the basics. There is still a lot about trading know-how, which you have to learn. It is also essential to read the listing document to understand a warran's terms. Find out more in the next few articles.
After all, warrants are complicated, high-risk instruments suitable only for those who are able to grasp the product features and take the risks. If in doubt, stay out.