A warrant is a specialized investment tool with its own language; call warrants, in-the-money warrants (a warrant with an exercise price which is below the market price of its underlying security), gearing and premiums are among the terms used. It's important to understand the main aspects of this vehicle before including it in your portfolio.
A warrant is a derivative, meaning it 'derives' its value from its underlying share. This is why the performance of a warrant will always depend on the performance of its underlying share.
A small movement in the price of the mother share can result in a surge or fall in the value of your warrant. Thus, expect this to happen and choose strategies that leverage and profit from this behavior.
Unlike a share, warrants carry an expiry date. The warrant tends to lose its value when it's close to expiring. Once it expires, it has no value and you lose the capital invested to buy the warrant. Buying and holding, as you would a share, is why 90% of warrant traders lose their capital.
If the underlying share price is above the warrant strike price (the predetermined price that the warrant holder is entitled to purchase or sell in the case of put warrant the underlying security), your call warrant is said to be in-the-money and you can exercise your right to buy the mother share at the strike (lower) price to sell at the market (higher) price.
There are costs involved when buying warrants – transaction costs and the time lag before you receive the underlying share after exercising the warrant. There're also occasions when a warrant trades at a discount. This incurs when the strike price and the cost to obtain the warrant are less than the price of the underlying share. Even tough this may look like an opportunity to make arbitrage profit, however, the risk of the underlying share price falling during the period between receiving the shares from exercising the warrant and their sale.
The whole process can take up to a month, during which the mother share can move in any direction. Warrants can also trade at a discount if the underlying share has just enjoyed spectacular run in price. Investors should avoid buying these discount warrants if they feel the high price of the mother share is unsustainable.
Warrants are the domain of short run traders. Some analysts recommend a particular trading strategy known as cash extraction. This strategy can be executed if you're holding a particular share that has appreciated in value. By selling the share and investing some of the proceeds into its warrants, you decrease your invested capital while maintaining exposure to further upside.
Many investors also trade in warrants because they sell at a fraction of the price of the underlying share and their leverage effect (a characteristic of warrants that enables the holder to enjoy larger percentage returns than the underlying security, at a lower price) allows the investors making bigger percentage gains when compared with conventional share investments.
For instance, share ABC may gain 30cent to close at $ 1.80, representing an increase of 20%, but a similar gain of 30cent for warrant ABC (from 50cent) to 80cent is an equivalent gain of 60%.
When the price paid for the warrant as well as its strike price is higher than the price of the underlying share, the warrant is trading at a premium. Meaning, the warrant's premium can crudely measure how much more expensive it is to acquire a share via a warrant compared with buying the share directly. Premiums are commonly used as a quick measure of the warrant's expensiveness. Because warrants are issued at a premium, investors must consider if it can appreciate to a level that allows recovery of the paid premium within the warrant's lifespan.
Another important factor to consider when selecting a warrant is volatility. A high volatility warrant, even tough more expensive, can very well generate more money than a low volatility warrant. High volatility means that the underlying share is more likely making big swings.
While warrants can offer a smart addition to a portfolio, keep in mind the following – your view of the underlying share is important; understand the unique nature of warrants and stay attentive to small movements in the market.