After introducing the concept of warrants as an alternative source of leverage, we now find ourselves in the position to further investigate what a warrant actually is and how it can benefit a trader or investor. Although it is initially quite hard to produce a definitive description because of their diverse and often unique specifications, warrants can be broadly divided into two categories: trading and investment. It can be argued that there is a huge grey area between these two polarized concepts. We shall use it as a broad generalisation in our investigation, however, to find how and where you can use warrants to benefit your short term speculative account as well as any long term investments you may have.
Before that, there is something more we need to cover in our general knowledge. We saw in the previous article that a warrant is a derivative and hence derives its value from some form of underlying asset. Should you decide to exercise the entitlements that a particular warrant in your possession has to offer, you will generally be doing so based upon some deviation in the price of this underlying asset. This begs the question, "what are those entitlements?" As with exchange traded options [ETOs], there are two main types of warrants and two main types of entitlements. These are call warrants and put warrants.
In essence, a call warrant is a warrant that gives the holder the right to buy the underlying asset for an agreed price, on or before a specified date. Simple. Yet remember that unlike an ETO, the agreement is with the warrant issuer, who is obliged to sell the asset at that agreed price, regardless of where the underlying price might be in the real world.
Let's look at a fictitious example of an equity warrant to illustrate this point:
Imagine that a certain call warrant carries the right to buy one share of ABC Pty at $1.50. The current share price is $1.25 and the price of the warrant is 10Â¢. If the share price rises to $1.70 the holder of the warrant can still buy the shares for $1.50 from the warrant issuer. This might require a large amount of capital, so an alternative is to simply sell on the warrant to another investor who wishes to own the actual underlying asset. Obviously, the warrant's value, and subsequently its price, will also have increased.
A put warrant gives the holder the right to sell the underlying asset to the warrant issuer for an agreed price on or before a specified date. Once again the warrant issuer is obliged to buy the underlying asset from you, regardless of where that underlying asset is actually trading in the real world.
For this example, let's imagine that you are in possession of a put warrant which carries the right to sell one share of XYZ Pty at $1.30. The warrant cost you 10Â¢. The share price of XYZ drops from $1.55 to 90Â¢. You can now do one of three things: Sell shares of XYZ you already own (if you do in fact have them in your portfolio), buy shares in the open market for 90Â¢ and then sell them to the warrant issuer for $1.30 or alternatively, as the value of the warrant will have increased, the warrant may be sold on for a profit.
The put and call warrants referred to so far have been for deliverable assets. If the underlying asset is not deliverable - as in the case of a share index, then the appropriate difference in the value of the warrant is paid to you in cash.
For some, this is back to basics, for others it is an entirely new derivative instrument. Either way, we have begun a journey that will lead to not only defining the complex nature of warrants, but will also present several compelling reasons to own them as trading and investment vehicles.