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What is a warrant?

Warrants give you the choice of buying and selling, or not, on fixed terms, for a period of time. For a small outlay, you can choose to exercise your warrant if the terms look attractive, or forfeit the small upfront premium if the deal's a no-no. Warrants always have shares as the underlying security, which is also their main distinction from options or forwards on currencies, for instance.

A warrant to buy something is known as a CALL WARRANT.
A warrant to sell something is known as a PUT WARRANT.

Call warrant prices move in the same direction as the price of the underlying security (usually just shortened to the "underlying", by the way), because the right to buy at a fixed price automatically becomes more valuable. Put warrant prices do the reverse. If the price of an "underlying" rises, the put warrant price will fall, because the right to sell at a fixed price becomes less valuable. A put warrant's price will rise if the value of the "underlying" falls.

Well, that's our delve into warrants for this week, but look out for next Friday's issue when you'll discover how warrants can make you big profits in a small amount of time and always with a completely known and controlled risk.
Profiting from warrants

For the most part, people buy warrants as insurance. They either take a wait-and-see approach in a stock they're interested in by using a call warrant or they hedge against loss by buying put warrants. But big profits in warrants can also be made by buying and reselling the warrants themselves. The key is to find the right warrant at the right price (premium).

Where premiums come from

he premium of a stock warrant depends partly on its relation to the underlying stock. This is shown by the warrant's strike price as related to the market price of the stock at the time of the warrant purchase. If the strike price of the warrant is equal to the current market price, the warrant's considered "at-the-money".

A call with a strike price above the market price or a put with a strike price below the market value is considered "out-of-the-money". It's out-of-the-money because it would be worthless if it expired today.

For example, if you buy a Widget Co. 1100 call, but the price is 1000c, it's out-of-the-money. If you buy a NWBC 1150 put when the stock is at 1170c, it's also out-of-the-money, because you wouldn't exercise either warrant. After all, why would you want to pay 1100c for a stock when you could get it for 1000c? Conversely, why would you sell a stock for 1150c when people are willing to pay 1170c for it?

You buy an out-of-the-money warrant because you believe that, given the volatility of the shares and the time you're guaranteed until expiration, the shares will move above 1100c - and be in the money. That's when the call's strike price is below the current market price or the put's strike price is above the market price. The warrant now has intrinsic value - a calculable worth.

Obviously, in-the-money warrants usually have a higher premium than out-of-the-money warrants. But out-of-the-money warrants move far more rapidly in favour of the buyer, percentage-wise, than in-the-money warrants do when the underlying price moves your way.

At, in or out of the money

Strike price = underlying instrument (at the money)

Strike price < underlying instrument (in the money)
Strike price > underlying instrument (out of the money)

Strike price = underlying instrument (at the money)

Strike price > underlying instrument (in the money)
Strike price < underlying instrument (out of the money)

Extrinsic value

If warrant prices were based on their intrinsic value alone, there would be no reason to buy warrants other than for insurance or hedging purposes. A warrant's premium would be fixed. But beyond a warrant's intrinsic value is its extrinsic value, the worth of the premium represented by time and volatility.

Remember, warrants are wasting assets. They have a fixed term of life and die a little every day until they reach their expiration date. Unlike stock investors, warrant investors may not have time to recoup losses in a sudden turnaround. That risk can be reflected in the premium.

For example, say it's January and you're looking to buy more Widget Co. warrants. Currently the stock is at 2200c, and you think it'll go up to at least 2500c, but you're not sure when. Well, you could buy a March 2500 call, or a September 2500 call. Both are calls on the same stock at the same strike price, but the premiums could still be miles apart. Why?

A warrant has no intrinsic value unless it's in the money. For the Widget Co. 2500 call warrant to be in the money, it must go up 300c. Would you rather have three months (March) for the stock to go up 300c or nine months (September)? Most people would pick nine months and would buy the September 2500 call, but it depends on when you expect the price to move and how much you're willing to pay for the extra time.

Warrants are speculative investments and their value is as much a slave to supply and demand as just about anything you can buy and sell. Also, the more risk someone's willing to accept, the more they're going to want to get paid for it. (Think car insurance. Bad drivers pay more than good drivers.)

With more investors clamouring for the same warrant anything can happen in nine months; less is likely to happen in three, so you can expect the premium on the longer-dated warrant to be higher. Remember, the longer the time until expiration, the more time the warrant has to meet your profit target. That's less risk for you… and that means a higher premium.

In South Africa, the market makers, like Standard Bank, have as their main priority the provision of a market and will often concentrate on factors that make trading difficult, for instance volumes and volatility.

Making big money from warrants

A brief review: A warrant's premium, the price you pay for the warrant, is determined by several factors. There's the intrinsic value, based on the underlying stock price. This is pretty much set in stone. Then there's the extrinsic value: The time value, the volatility and the risk psychology. These can push the price of a warrant up or down significantly.

The secret: Buy a warrant when nobody wants it, then resell it when everybody seems to need it.

In short, find a cheap warrant on a stock you think is in for a big move, then buy it. When the move happens, the price of your warrant will move too. Your warrant will be in demand and investors will be willing to pay you for your warrant. If you sell, you have instant profits.

I'll use an imaginary example to show you what I mean

Imagine a company called Headbanger's shares are trading at 750c and you bought a warrant in the market to buy the shares at that price. In other words, it's an at-the-money call warrant with a strike price of 750. Let's say it cost you 25c.

Now imagine Headbanger releases sales figures that show that its new Gti sports model is taking the country by storm. The share price responds by suddenly going up 100c. The warrant will be worth more. Instead of the underlying share price being roughly the same as the exercise price of the warrant - 750c -  it's 100c higher.

This means you could exercise the warrant and make an instant profit by selling in the market - at 850c - the shares you're getting at 750c via the warrant.

What in fact happens is that the price of the warrant reflects the change in the underlying share price. So instead of being able to buy the warrant for 25c, its price might now be around 100c - to reflect the 100c rise in the price of the underlying shares.

So any percentage change in the price of the shares is usually magnified in the price of the warrants, usually around four or five times. In Headbanger's case, the price of the shares rose from 750c to 850c, or 13%. The price of the warrants rose from 25c to around 100c, a gain of 300%.

Although this process can work in reverse if the price of the underlying share falls, you have a strict limit on your losses. You can't lose more than the original cost of the warrant.

The big thing to remember if you're using warrants to speculate - as most warrant investors do - is that your judgement about the magnitude and direction of a change in price of the underlying has to be right. But that's not all. It has to be right within the timescale of the warrant.

It's no good being wrong at any time. But it's also no good being right about the price of a share if the move you expect happens after the warrant you've bought has expired.
The consept of warrants by look at your everyday life

You can buy warrants as a sort of insurance, or hedge, to protect your capital or to profit if the market moves in your direction.

If you have car or house insurance you are, in effect, using warrants. You pay the insurance company a non-refundable premium (an amount you're prepared to write off) to protect your investment - the house or the car. You think there's a chance that your investment could fall in value (your car gets pranged, for instance) so you pay a premium to cover yourself. The value of your asset falls, but your insurance policy - your warrant - covers the loss and protects your investment. This is an everyday example of a long hedge.

Introducing the power of leverage

But warrants can also be used to speculate for a large return on your investment by putting up a relatively small amount of risk capital. Here's another everyday example you might have experienced to help you understand. Say a property developer is selling a new block of flats in an up-and-coming area. You like the look of them and want to buy, but they're not going to be ready for a year. To secure the flat at the current price of R500,000, you place a non-refundable deposit - the premium - with the developer, which is 10% of the purchase price, or R50,000.

This premium gives you the right, but not the obligation, to buy the flat for R500,000 in a year. Meanwhile, in return for the premium, the developer is now obliged to sell you the flat in a year's time for R500,000, if you want it. He has no choice.

A year passes and the price of the flats in that area have gone ballistic - they're now worth R850,000. You can now exercise your right to purchase the flat for R500,000, knowing you can sell it for R850,000. That's a R300,000 increase against a R50,000 stake - a R300,000 profit or staggering 600% return on your investment.

And that's what this Investment Academy (and those over the next few Fridays) is all about: How to make money from trading warrants. But first, I want to give you a little history lesson on the origins of warrants. Knowing where warrants come from will help you understand how these instruments work and why they can be so useful.

A brief history

Before we get going, I need to explain that worldwide there's a difference between options and warrants but, in South Africa, the two concepts are the same. While both options and warrants give an investor the right, but not the obligation, to buy a stock at a future date, globally options are financial instruments provided by financial houses, while warrants are issued by the company itself. In South Africa, both are issued by financial institutions.

Both options and warrants are derivatives. Derivative is a jargon term that covers any form of investment whose price or value derives from something else.

A derivatives contract can be formulated in several different ways. It can simply be an agreement to buy something from, or sell something to, someone at the indicated price at a specified time in the future. This is called a future.

But you might want to have the choice of buying (or selling) something - or not - at a fixed point in the future. In other words, you want to have the option of buying (or selling) it. But it isn't in your interest to do so; you don't want to be forced into it.

Warrants and options have been around since ancient times (as we saw in last Friday's Investment Academy). Merchants would pay a small amount of capital on anticipated crops or ocean-bound cargo.

When the crop was harvested or the shipment arrived, the merchant was given the first opportunity to buy the goods.

As investing evolved, so did options trading. Futures trading led to futures options. And as companies began to issue stocks, it was only natural that options would evolve to cover them as well.

Jumping ahead, using traded options as a financial tool became popular when, in 1900, the Put and Call Brokers and Dealers Association was formed in the US. The Association made it much easier for private investors to get into the market. Unfortunately, there were some problems with the system that allowed unscrupulous brokers to take advantage of those common investors.

In fact, use of options and related instruments got out of hand in the 1920s, exacerbating some people's losses when the market crashed. In the 1930s, Congress stepped in to try and regulate the options market.

Options were limited to strictly regulated over-the-counter transactions arranged by the Put & Call Dealers Association and endorsed by New York Stock Exchange members.

Options became mainstream again in 1973, when the Chicago Board of Options Exchange opened as the first American options exchange, with member market makers ready to serve investors with a two-way option market. Risk-takers who wanted to buy or sell options could now be rapidly accommodated.

The change from over-the-counter options was astounding. Contract terms were standardised, making them more accessible to the average investor, and their popularity skyrocketed. In fact, they became so popular that the Securities and Exchange Commission halted expansion of the industry in 1977 and spent years reviewing it. But finding nothing wrong, more exchanges were opened and more investments were optioned - including futures on commodity exchanges. Options had come full circle.

The point is, the options and warrants world is very big. But it's also regulated to keep everyone honest. In SA, the Financial Services Board (FSB), under the auspices of the Stock Exchange Control Act, ensures that dealing in warrants is regulated so you, the private investor, is protected. The close monitoring helps limit your risks, at the very least giving some fraud protection and recourse. That doesn't mean you don't have to be careful when trading, but it does mean trading warrants is as safe as trading stocks, bonds or property. (Of course, that doesn't mean that trading warrants is risk-free… but we'll get to that in a future issue.)

The most important thing to see is that, even though there are so many warrants to choose from, they all share the same basic fundamentals.

Once you understand how warrants in one investment work, you can apply those principles to investment options in completely unrelated fields. And that's called diversity.

Let's have a look at the two basic types of warrants you can trade...

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How do you buy warrants
1. Through a broker

Choose your broker wisely. You may already have a broker you trust. If so, excellent, but make sure he has experience buying, selling and exercising warrants. And above all, don't forget to ask about commission rates.

Whenever you buy a warrant, there's a commission charged.

Whenever you sell that warrant back into the marketplace, there's a commission charged. The size of that commission adversely affects your capital. If you go with a full-service broker, expect to pay higher commissions. But, on the plus side, you can also expect a wider range of services and you're likely to receive more personal attention. Discount and online brokers often charge less commission but, for the most part, you're on your own.

At first glance, you may think it's wise to confine your warrants buying activity to a discount or online broker.
But this might cost you thousands of rands if your service broker at the discount house can't execute your orders quickly or keep track of your positions. You'll find it often pays to conduct your warrants business with a broker knowledgeable about warrants markets - and who really cares for customers who take warrant-buying risks.

If you want to stay with your broker, see if you can get a reduced rate on your warrants trades. Years ago, there were fixed commissions for warrants as well as stocks. But today, even the largest brokerage firms will set a lower rate for your warrants commission if you're a volume buyer. But whoever your broker is, you can't buy warrants unless you've filled out certain paperwork. Make sure you read the literature your broker's required to give you, fill out the forms and set up a cash account with enough money to pay in full for the warrants you want to buy.

Terms of the trade - market or limit?

Now you're ready to trade. When you're ready to purchase a warrant, you instruct your broker to buy to open. This means you're making a new fully-paid-for warrant position which, when executed, will be entered into the exchange computer. You can tell your broker to buy the warrant immediately, paying whatever the going rate is. This is called a market order.

Or you can set a limit price when you place your order, meaning that your order won't be executed until the warrant hits a certain price.
This is known as a limit order. I prefer limit orders. Your order might not get filled, but your risk is known and there are always other opportunities in warrants.

For example, if you tell your broker to put in a market order to buy a March 2500 call warrant on Widget Co. to open, you'll pay whatever the current warrant price is. If the warrant's price is moving fast, your order could be executed for far more than you'd be willing to pay otherwise.

On the other hand, if you tell your broker to put in a limit order to buy a March 2500 call warrant for a premium of R1,100 to open, your trade won't be executed unless the price is below R1,100. Your risk is kept firmly in check, since you know almost exactly how much you're paying for the warrant. Unfortunately, this also means there's a chance your warrant order will never be executed. The premium may never fall below R1,100.

Don't forget about an order

Another thing to remember is to cancel an order you're no longer interested in. If your order is still in your broker's computer when the limit price is hit, you'll buy the warrant.
For instance, you instruct your broker to buy a Widget Co. March 2500 call warrant for a premium of R1,100 to open. When you call your broker, the warrant's at R1,050. But by the time your broker's ready to execute the order, the price is R1,150. So your order remains in the computer unfilled. A day later, the warrant's jumped to R1,800 - and your order is still unfilled and still in the computer. Two weeks later, the price collapses. When it hits R1,100, the order's executed. Without meaning to, you've now spent R1,100 on a warrant that's already doubled and is now sinking.

This is an extreme example, but it illustrates two important points.

Using limit prices is a much better idea than not using them. But you must set a sensible limit price. Make it big enough to account for volatility, but not so wide that you lose profits. Above all, keep track of all your outstanding warrant orders and cancel ones that turn against you.

When it's time to sell your warrant, tell your broker to resell to close the position. You sell your warrant to the market, receiving money in exchange for giving up your rights to the underlying investment without gaining an obligation. You can sell for a profit or for a loss, depending on what the market's willing to pay, but either way, you're out of the game. Make sure you get the phrasing right! Remember, warrants originally come from an investor looking to make money by writing, or selling, warrants to other investors. If you don't make it clear that you're closing an open position, not opening a new one by selling a warrant, you may accidentally become a warrant writer. And warrant writers have an obligation to fulfill the terms of an options contract.

Protect your losses

You can also give your broker a stop loss order. This is an instruction to your broker to resell your holding if the price falls to a certain level to prevent further losses. This helps limit your risk and lock-in gains. If you bought your warrant at R1,100 and it goes to R2,000, you might tell your broker to put in a stop loss at R1,500. If the price hits R1,500, your broker will execute a sell order. The upside is that you're almost guaranteed retaining your profits. But, keep in mind, the stop loss only tells your broker to start executing the order. If the warrant's dropping rapidly, the price could be below R1,500 by the time your order hits the trading floor.

Finally, of course, you might choose to exercise your warrant at anytime.

If you own a successful call and wish to take possession of the shares at the lower than market price, instruct your broker to exercise your call and position the shares in your portfolio at the strike price of the call.

Make sure you have enough cash in your account to buy the shares, and don't forget that with stock warrants you're buying 1,000 shares of the stock. Conversely, if you've bought a successful put, tell your broker to exercise your put and sell the shares, crediting your account for the proceeds at the stock price.

Generally, only look to exercise a few days before expiry if you decide to go this route. In most cases, though, warrants are traded rather than exercised, picking up on the time value. You can usually look to sell up to three months before expiry.

If a trade goes against you and you're unable to sell your warrant (bid goes to 0), then it'll expire worthless. There's nothing you or your broker can do in this case.

The 7 keys to successful warrant plays

** Don't be greedy; small profits never hurt anybody.
** Protect principle by setting sensible stops.
** Never lose more than 50% of the premium if you can help it.
** Watch your warrant positions daily or have your broker do this for you.
** Don't overbuy any warrant position.
** Don't overpay for any warrants.
** Understand warrants pricing.
A Strategie to win with warrants

It doesn't matter which market you trade... equities, bonds, commodities or currencies… the strategies are the same. And the more you learn about warrants, the more strategies you'll come across. But, most of them are just variations on a theme, allowing those in expensively paid jobs to jargonise, confusing everyone in the process. At the Investment Academy, we're here to remove the market mystique and put it down in plain English for you.

You might think a warrant's price is pretty simple. It's what the market says it's worth - no more and no less.

In a sense that's true. But when the academic experts of three decades ago discovered what made warrant prices tick, they discovered several different factors influenced them. By understanding each component and how they interact, valuing a warrant, and working out which one is the best to buy and sell, becomes a bit easier.

Most warrant issuers in South Africa have dedicated websites.

Pick a warrant at random and you'll see that it shows a matrix of expiry dates and exercise (or strike) prices. One thing you'll notice for each table is that, in the case of call warrants, as the strike prices rise, the value of the warrant falls. That's because the warrant moves further out of the money relative to the current price of the underlying share.

In the same way, even for a warrant that's some way out of the money, the value placed on warrants with a longer expiry period will be greater than the ones with less time to go. If we're, say, in September now, the price of a warrant (with the same strike price) that expires in three months' time will be less than one that expires in six months, which in turn will be less than one that expires in nine months' time.

The all-important time value

This pattern reflects one of the big factors in a warrants price - its so-called "time value".

Definition: Time value is what investors pay for the chance that a profitable move in the price of the underlying shares might occur between now and when the warrant expires.

The time value of a warrant with longer to go to expiry will be bigger, all other things being equal, than one with less to run. That's because the probability of that all-important move occurring is that much greater. It might not be that big a chance, but hope springs eternal, as they say.

What we know about a warrant's price

If it's in the money, it has some intrinsic value, shown by the difference between the strike price and the price of the underlying. The difference is the secret ingredient of time value, governed by how long the warrant has to go before expiry.

If, for example, Headbanger Automotive March 260 calls are priced at 60c and the underlying shares are 300c, the intrinsic value is 40c (300c-260c). The time value is 20c (60c-40c).

But, this isn't the end of the story. Not only is time value influenced by how long the warrant has to go to expiry, but also by how volatile the underlying shares are.

Volatility plays a massive part in the price

This makes a lot of sense. The longer a warrant has to run, the bigger the chance the underlying will move in your favour. But if the shares are inherently volatile, then the chance of a movement in the right direction's probably going to increase too.

Using simple warrant pricing software, a warrant's "fair" price can be worked out for any given level of volatility (other things being equal). Reversing the calculation, the volatility implied by the current market price of the warrant can be calculated. This means you can see what impact a movement to a new higher or lower level of volatility would have on the price of the warrant, other things being equal.

This isn't academic. Volatility can change sharply over short periods for a variety of reasons, including market factors and events relating to the underlying shares.

Changes in volatility can reinforce or dampen changes in warrant prices occurring as a result of the other factors. So being clear on exactly what volatility means is central to the idea behind warrants trading and making money from it.

Warrant issuers in South Africa generally try and maintain volatility and won't simply make ad hoc changes to prices. As market makers, that won't be in their interests.