Warrants can be classified into call and put. A bullish investor may buy a call warrant to benefit from upward share price movements, while a bearish investor may buy a put warrant to capitalise on downward share price movements. A risk-averse investor may buy a put warrant to hedge against the downside risk of the underlying asset he holds.
Sounds great. What are the payoffs of buying a warrant?
Call warrants give you the right to buy a given amount of the underlying asset at a predetermined exercise price within a certain period.
Suppose you buy a call warrant at $2, with stock A as the underlying asset and an exercise price of $40. If the price of stock A is above $42 (the breakeven point) on the expiry date, you can make a potential profit as illustrated in the following diagram. The higher the stock price, the higher your return. However, if the stock price lies between $40 and $42, you can still exercise the warrant, but at a loss after deducting the warrant price. If the stock price is at or below $40 (i.e. out-of-the-money), it will not be worthwhile to exercise your warrant. In such a case, your initial outlay in the warrant is entirely lost!
Put warrants give you the right to sell a given amount of the underlying asset at a predetermined exercise price within a certain period.
Suppose you buy a put warrant at $1, with underlying stock B and exercise price of $30. If the price of stock B is below $29 (the breakeven point) on the expiry date, you can make a potential profit as illustrated on the following diagram. The lower the stock price, the higher your return. But, if the stock price lies between $29 and $30, you can still exercise the warrant, but at a loss after deducting the warrant price. If the stock price is at or above $30, you will not exercise the out-of-the-money warrant and face a loss equal to its purchase price!
Remember, even though the potential gain of buying a warrant can be substantial, your warrant can become worthless if on the expiry day, it is out-of-the-money and is not worth exercising.
What determines the price of a warrant?
A derivative warrant's relationship with its underlying asset is not simply one-to-one. Based on the option pricing theory, apart from the exercise price, there are five factors affecting the theoretical price of a warrant: the underlying asset price, expected volatility of the underlying asset price, time to expiry, interest rate and dividends expected to be paid by the underlying asset. Assuming other factors remain constant, the theoretical impact of changes in each factor on both call and put warrants is illustrated below:
Call and put warrants react in an opposite way to changes in their underlying asset price. When the underlying asset price goes up, a call warrant's price will go up but a put warrant's price will fall. For both call and put warrants, the higher the expected volatility of the underlying asset price, the higher the warrant price. Both call and put warrants lose their value as time passes by. Finally, changes in interest rate and expected dividends will have different impacts on the prices of call and put warrants.
The above factors altogether determine the "theoretical" price of a warrant. However, the warrant may not be traded at that price. The "market" price may move away from the theoretical price, depending on the short-term demand for and supply of that warrant (e.g. number of that warrant outstanding in the market, availability of other warrants with the same underlying asset) and other factors such as the creditworthiness of the warrant issuer.
Given there are many other factors affecting warrant prices, you should bear in mind that warrant prices do not simply go up even if the underlying asset prices move in the right direction. The price movement of a warrant may not be proportionate, or may even be opposite, to the price movement of the underlying asset. For example, warrants' implied volatility, the number of outstanding warrants in the market, and supply of other warrants with the same underlying asset may affect the price of a warrant.
You may refer to the "FAQ - Derivative warrants" posted on individual issuers' websites or the HKEx website to understand more about warrants.