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Equity Warrants

By Sandy Naidu | February 11, 2008

Equity Warrants are short dated securities based on a underlying share that gives you the option to buy or sell the underlying share at an already decided price. With equity warrants you can trade at a much lesser initial investment than what you would with the underlying share on which this warrant is based. So you are basically punting on the underlying share using a smaller outlay than what would be needed for the underlying shares. These warrants have a high risk/return profile.

Not all equity warrants are alike. The features of an equity warrant depends on the issuer of the warrant. In Australia, investment banks like Macquarie Bank, ABN Amro, Citigroup etc offer equity warrants. These warrants trade on Australian Stock Exchange like all the other ordinary stocks. You can either buy the warrants from the issuer at the time of issue or buy them later through a broker (in the secondary market).

The following terms define the features of an equity warrant:

Call Or Put Warrants: If you have the right to buy the underlying share on or before the end of the equity warrant term then it is called a call warrant. If you have the right to sell the underlying share on or before the end of the equity warrant term then it is called a put warrant.

Expiry Date: This is the date on which the equity warrant expires. The equity warrant is useless after the expiry date.

American Or European: If you have the right to exercise the warrant anytime on or before the expiry date then it is called an American exercise style warrant. If you have the right to exercise the warrant only on the expiry date then it is called an European exercise style warrant.

Exercise Price (also called Strike Price): This is the price at which you can exercise the warrant - the price at which you can buy or sell the underlying share.

Conversion Ratio: This is the number of equity warrants you need to buy one underlying share. If the ratio is 4:1, it means you need 4 equity warrants to buy one underlying share.

Equity warrants have a 6 letter ASX code rather than the three letter ASX code for the traditional stocks. Example of an equity warrant is ‘CBAWZE’. The first three letters indicates the underlying stock (in this case CBA which is the code for Commonwealth Bank). The fourth letter indicates the type of warrant - ‘W’ means equity, index and currency warrants; ‘I’ means instalments; ‘E’ means endowments and ‘X’ means all other types. In our example it is ‘W’ meaning ‘equity warrants’. The fifth letter indicates the issuer of the warrant - in our case its ‘Z’ which is for ABN Amro. The last letter denotes the type of equity warrant it is - if it is between A and O it is a call warrant and if it is between P and Z it is a put warrant. In our example it is a call equity warrant.

People buy call warrants if they expect the price of the underlying share to rise. Lets say you you buy a call warrant with Strike Price of 12 dollars for a stock ‘ABC’. Now you are buying call warrant hoping that the price would rise. Lets say at the time of expiry of your call warrant the stock ABC’s price is 15 dollars. So you see the price has gone up as you expected. Since the price has gone up you actually make a profit (because you can buy ABC at 12 dollars and sell it at 15 dollars market price). Now if the price of the stock had fallen to say 10 dollars, you make a loss…Your call warrant is deemed useless. Why would you exercise your call warrant and buy the stock at 12 dollars when you can buy the same stock for 10 dollars.

People buy put warrants when they expect the price of the underlying share to fall. Lets say you you buy a put warrant with a Strike Price of 12 dollars for a stock ‘ABC’. Now you are buying put warrant hoping that the price would fall. Lets say at the time of expiry of your put warrant the stock ABC’s price is 10 dollars. So you see the price has fallen as you expected. Since the price has fallen you actually make a profit (because you can buy ABC for 10 dollars and sell it to the warrant issuer at 12 dollars). Now if the price of the stock had risen to say 15 dollars, you make a loss…Your put warrant is deemed useless. Why would you exercise your put warrant and sell the stock at 15 dollars when you bought it for 12 dollars.

In summary - Buy call warrants when you expect the price to rise. Buy put warrants when you expect the price to fall.

The prices of warrants is determined by a number of market factors. A few factors which affect the price are:
When the conversion ratio is high the price of that warrant is low and similarly a lower conversion ratio means a higher warrant price.
When the exercise price is high then the lower the price of a call warrant and higher the price of a put warrant.
The closer the maturity date the higher, lower the price of a call warrant and higher the price of a put warrant.

It is important to understand all the features before you buy your warrants. And remember that warrants give you a high return but they also have a high level of risk. Make sure you make an informed decision.