advanced
Now you are reading
Option warrants – is it worth using an option substitute?
0

Option warrants – is it worth using an option substitute?

created Forex ClubApril 30 2024

They recently debuted on the Warsaw Stock Exchange option warrants on selected indices (WIG 20, mWIG40, DAX) and some shares (including PKO, Pekao, KGHM, Orlen, Pepco, Allegro). The above-mentioned instrument is not very widely known to Polish investors, but in certain situations it can be an effective tool to achieve high profits. In today's article you will learn about the advantages and disadvantages of using warrants and why this instrument may be riskier than options.


READ NECESSARY: WHAT ARE THE OPTIONS? INTRODUCTION


What are option warrants?

A warrant is a security issued by financial institutions and may be traded on a stock exchange. It is also a derivative instrument. Warrants give the right to buy (Call) or sale (put) of the underlying instrument at a predetermined price and time. So it is an instrument similar to an option. However, in the case of warrants, it is not possible to take a short position, i.e. short call and short put. This means that not all strategies can be carried out on warrants (e.g. bull spread or bear spread). Only directional trades are possible. Unlike options, warrants have their issuers, who must provide information about the product in a special document informing about the terms of issue (in the case of options, there is no such requirement).

As in the case of options, warrants also have a "sewn-in" financial leverage. This is because the investor only has to pay a small nominal value of the contract. This may seem complicated, but I'll use an example. There is a call warrant for KGHM listed on the market with an exercise price of PLN 120. The value of such a warrant is PLN 1 and one warrant corresponds to one share. In this example, the market price of KGHM was PLN 100. The investor purchased warrants giving exposure to 1000 shares of KGHM. He paid PLN 1000 for the call warrant. If the price of KGHM is PLN 125 on the expiry date, the value of the warrant will increase to PLN 5. This means that the investor will achieve a profit of PLN 4000 (i.e. 400%), even though the price of the underlying instrument increased much less (i.e. 25%). What would happen if the price increased from PLN 100 to PLN 119,9? The investor would lose all of the invested capital.

Use of warrants

Option warrants can be used in many ways. Among the most popular of them are:

  • securing positions,
  • directional transactions.

Hedging your position, in other words hedging, are transactions that protect the investor against a negative scenario. If an investor holds shares of a company, he or she can use option warrants to minimize the situation when a decline in the share price causes a decrease in the value of the portfolio. Let's use an example. The investor owns 300 shares of KGHM. Currently, their exchange rate is PLN 112. At the same time, the investor is afraid that the shares of the copper and silver producer may experience a significant decline in the short term. For this purpose, the investor purchased put warrants for 300 shares with an exercise price of PLN 110, paying a premium of PLN 3,25. This means that the investor is protected against a drop in the price of KGHM shares below PLN 106,75. For example, if the share price drops to PLN 100, the investor will receive PLN 6,75 of profit from the warrant (PLN 110 - PLN 100 - PLN 3,25). As a result, the profit from the derivative instrument may partially cover the losses from the stock portfolio. As you might guess, warrants can be used to protect a short position in the futures market or short sale. To protect yourself, you can use the call option.

Directional trades are a second way to use warrants. In this case, the investor does not want to protect himself against an unfavorable price change but to make money from the price change. In this case, the investor tries to predict the price behavior in the future and take a position. Warrants enable:

  1. game for growth (CALL),
  2. drop game (PUT),
  3. game for increasing volatility (CALL + PUT).

In the case of the last strategy, the investor simultaneously buys a put and a call option, which will allow him to make a profit only in the event of a significant change in the price of the underlying instrument.

Option warrants on the WSE – mechanics

Option warrants for Warsaw Stock Exchange are issued exclusively by the issuer. The exercise date of this type of instrument usually occurs on the exercise date of the option. However, they also exist American-type warrants, which can be performed on any day when the stock exchange is trading. However, if completed early, the time bonus is lost.

This type of instrument is valued in a similar way to options. The price depends on many factors. These include:

  • the warrant exercise price,
  • time to expiry,
  • volatility of the underlying instrument.

In terms of price, the more ITM (in-the-money) a warrant is, the more expensive it is. This is logical. We will pay much more for a call warrant for KGHM shares if the instrument price is PLN 50 than if the warrant has an exercise price of PLN 200. As with options, is the premium consists of intrinsic and time value. The more ITM an option is, the greater the intrinsic value of the option.

Time to expiration also plays a role in valuing warrants. The more days left until the warrant expires, the greater the probability that our warrant will expire "at price". Therefore, the issuer demands a higher price for the warrant for its greater risk.

A very important parameter in the case of warrants is the so-called multiplier (subscription rate). If its value is 0,5, it means that one warrant corresponds to 0,5 shares. Therefore, if an investor wants to purchase 200 shares, he or she must buy 400 call warrants. That's why, that the issuer may use different multipliers before carrying out the transaction, we encourage you to read the terms and conditions of the issue.


DOWNLOAD FOR FREE: Futures and Options [Ebook]


How to decipher the name of the warrants?

A significant difficulty for novice investors is deciphering the name of the warrants. This is an art because there is, for example, a product like this: RBIWC0624ALE1. It seems complicated, but just a little practice and everything becomes clear. Let's break this name down into individual "syllables":

  • RBI – name of the issuer, i.e. Raiffeisen,
  • W – warrant,
  • C – call (game for growth),
  • 0624 – expiration date, in this case June 2024 (also on the 3rd Friday of the month),
  • SALE – underlying instrument,
  • 1 – strike (each instrument has several strikes).

Okay, but what is the strike price of this instrument? It is worth taking a look at the instrument's specifications. The exercise price of this warrant is PLN 32. However, in the case of:

  • strike “” – PLN 30 – in this case, the name of the instrument is RBIWC0624ALE,
  • strike “2” – PLN 34,
  • strike “3” – PLN 36,

It is also worth looking at the spread, which is different for instruments. Typically, the difference between the purchase and sale price of a warrant ranges from 6-10%. This is a lot, but it should be remembered that this type of instrument is characterized by high volatility. The exception are deep OTM warrants, where the spread can be as high as 50% or 100%. Let's look at the spreads of individual warrants on Allegro (as of March 28.03.2024, XNUMX):

  • RBIWC0624ALE (call PLN 30) – spread 9,09%
  • RBIWC0624ALE1 (call PLN 32)  – spread 9,38%
  • RBIWC0624ALE2 (call PLN 34)  – spread 9,09%
  • RBIWC0624ALE3 (call PLN 36)  – spread 13,36%

Let us now use the example of the RBIWC0624ALE warrant, with an exercise price of PLN 30. The multiplier of this instrument is 0,1. This means you need to buy 10 warrants to have the equivalent of one share. How can we estimate the break even level if we buy one  warrant? We need to divide the value of the warrant (PLN 0,48) by the multiplier (0,1). The result is PLN 4,8, we add this amount to the exercise price (PLN 30). The calculation gives us a level of PLN 34,8. Taking into account that the current price of the underlying instrument is PLN 33,08, the option has a high intrinsic value (PLN 3,08 * multiplier = PLN 0,308). So it is an ITM warrant.

00 warrans

Source: Raiffeisen (warrant issuer)

Advantages of investing in option warrants

Investing in warrants has a number of advantages. The most important of them include:

  • the ability to hedge positions on the cash market,
  • embedded financial leverage,
  • limited loss to the amount of invested capital,
  • possibility of building a long-short strategy.

While the first three points seem obvious, it is worth looking at the fourth point. The possibility of trading warrants on mWIG40 gives you the opportunity to play a long-short strategy. For example, an investor purchases selected shares of selected companies from mWIG40 and then buys a put option on mWIG40. If his predictions come true and the shares perform better than the broader market, the investor will generate a positive rate of return even during a bear market.

Disadvantages of investing in option warrants

Like any instrument, warrants also have their drawbacks. The largest of them include:

  • counterparty risk,
  • high spreads,
  • no possibility to issue warrants,
  • complexity of the instrument.

The counterparty risk results from the fact that the investor cannot always be 100% sure that the issuer of the warrants will be able to fulfill its obligations. Therefore, it is a slightly more dangerous instrument than options, where the issuer of the instrument must submit a security deposit, the level of which is regularly monitored.

It is also worth saying a little more about the inability to exhibit the instrument. This is a big disadvantage and does not allow you to create a bull spread or bear spread strategy. Moreover, it is not possible to use a strategy such as a covered call, which gives the possibility of additional earnings from a portfolio of shares ETFs.

Summation

Warrants are a substitute for options that are not available for some instruments on the Warsaw Stock Exchange (shares of Polish companies, mWIG40 index). Thanks to warrants, you can use instruments that have an asymmetric risk distribution. Warrants provide the opportunity to achieve multiple profits thanks to financial leverage with a maximum loss of the invested capital. Unfortunately, warrants have their drawbacks. Among them is quite wide spread and counterparty risk. Another weak point is no possibility of taking a short position on a warrant, which significantly limits the construction of "option"-like strategies.

What do you think?
I like it
0%
Interesting
100%
Heh ...
0%
Shock!
0%
I do not like
0%
Detriment
0%
About the Author
Forex Club
Forex Club is one of the largest and oldest Polish investment portals - forex and trading tools. It is an original project launched in 2008 and a recognizable brand focused on the currency market.
Comments

Leave a Response