With warrants, investors use leverage to bet on rising (call option) or falling (put option) prices of the underlying asset. In addition to the performance of the underlying asset, its volatility also has a significant impact on the pricing of a warrant.
How do warrants work?
With a warrant, the investor acquires the right – but not the obligation – to buy (call warrant) or sell (put warrant) a specific underlying asset at a specific strike price during a specific time period (American-style) or at a specific point in time (European-style). Warrants can be used to trade various underlying assets, such as individual stocks, an index, a currency’s performance, or a commodity. Compared to a direct investment, warrants offer the advantage that profits can be generated even with relatively small amounts of capital, thanks to the leverage effect.
A warrant has four characteristics: The underlying asset is the asset on which the warrant is based, such as a stock. The subscription ratio indicates how many warrants correspond to one underlying asset. If the subscription ratio is 1:1, the option right can be exercised with a single warrant; if it is 0.1, 10 warrants are needed to purchase, for example, 1 share. The strike price specifies the price at which the option right can be exercised. The term refers to the time period (American-style) or the specific date (European-style) during which this right is valid.
There are two types of warrants: call and put warrants.
Call warrants
If you believe the underlying asset has upside potential, you can profit disproportionately from a price increase using call warrants. This is because with a call warrant, the investor acquires the right to “demand” (call) delivery of the underlying asset at a predetermined price.
Example
To purchase a share at a strike price of 100 euros, a warrant worth 3 euros is bought, assuming a subscription ratio of 1:1. If the share price remains below 100 euros throughout the term, the warrant is of no use to the investor. The investor only makes a profit if the share price exceeds 103 euros (strike price plus the price paid for the option). If the share price rises to 110 euros, a profit of 7 euros per warrant can be made. If the price of the underlying asset does not rise above 100 euros, the warrant is worthless. The capital used to purchase the warrants is lost.
Put warrants
With put warrants, investors bet on falling markets. They acquire the right to “sell” (or “put”) the underlying asset to the issuer; that is, the issuer agrees to purchase the underlying asset from the investor at a specified price.
Example
A premium of 3 euros is paid for the option to sell a share at 100 euros. If the share price falls to 96 euros, the investor can still sell the share for 100 euros. Their profit per warrant is 1 euro. If the price falls to 80 euros, the profit per warrant is 17 euros. If the share price rises above 100 euros, the put warrant expires worthless.
Important considerations
Warrants offer the potential for disproportionately high returns, but also carry an increased risk of total loss. Furthermore, the price of a warrant is influenced not only by the performance of the underlying asset but also by other factors such as volatility, time value, and interest rates. Due to their complexity and the leverage effect, warrants are suitable only for experienced investors who monitor their positions on an ongoing basis.
