Valuing a warrant based on implied volatility

Implied volatility, a frequently mentioned term about derivative warrants (known as “warrants”), is an important metric to evaluate the value of a warrant. Implied volatility of a warrant represents the market expectation of the volatility in the warrant’s underlying asset price (or level if the underlying asset is an index) in the future. It is generally used as an indicator to determine whether a warrant is expensive or not.

We all know that we should never pick a stock solely based on its price or think that a stock with a low price is always a good buy, while a stock with a high price is too expensive. The same rules apply to warrants too. We should not judge a warrant just by its price. We should look at its implied volatility as it is an important factor that investors must understand before buying warrants.

To understand the impact of implied volatility on warrants pricing, we first need to know that the theoretical price of a warrant is the sum of its intrinsic value and time value. Since only in-the-money warrants have an intrinsic value (call warrants: The underlying asset price is higher than the strike price (or level if the underlying asset is an index); put warrants: The underlying asset price is lower than the strike price), the value of a warrant depends on, to a certain extent, if it is in-the-money before expiration.

Both time to expiry and volatility of the underlying asset price can affect a warrant’s probability of becoming in-the-money. A later expiry date or higher volatility of the underlying asset price will increase such probability. Therefore, theoretically, the warrant price should rise when its implied volatility goes up.

Know more about the jargons of warrants

Factors affecting warrant price

To evaluate whether a stock is expensive or not, we usually use its P/E ratio as a quick reference, not its share price. Similarly, to assess whether a warrant is expensive, we use implied volatility, not warrant price and premium. This is because the warrant price and premium are determined by a number of factors, such as time to expiry. For warrants with the same underlying asset, the higher the implied volatility, the more expensive the warrant is. Therefore, when selecting a warrant, we can choose one with lower implied volatility among those with similar strike prices and expiry dates. Investors can now check the implied volatility of individual warrant through newspapers, financial websites, information providers and warrant issuers.

As the implied volatility is not static, it is not enough to just compare this metric among warrants. The stability of the implied volatility should also be considered. If we buy a warrant with high implied volatility and its implied volatility then dives, the warrant price may also drop. A warrant with a high price is more sensitive to declining implied volatility.

Here are some points to note regarding implied volatility:

• Implied volatility is not a historical volatility but a forward-looking metric that reflects the market expectation on the price movement of an underlying asset. The historical volatility of an underlying asset can be determined by referring to its past price movements; while implied volatility is determined by using the option pricing formula backward-computing from the market price of the options.
• The level of implied volatility of a warrant is determined by the issuer based on the implied volatility of the related listed and over-the-counter options, the historical volatility of the underlying asset, the issuer’s market expectation and the cost of issuing the warrant. Even warrants with similar terms may have different implied volatilities.
• Implied volatility only reflects the market expectation on the volatility, not its direction, of the underlying asset price.

We can always compare the implied volatility of different warrants to see which warrant is lower-priced. However, there is no guideline on what constitute as high implied volatility and what is low; and a warrant with lower implied volatility does not necessarily mean it is the right one for you. There always be a reason behind the high or low implied volatility, so it is important to choose a level perceived as reasonable. Always ask yourself two questions when choosing warrants: Is the higher implied volatility justified? Is the cheaper warrant better? After all, implied volatility is just one of the many factors affecting the pricing of warrants, and investors should also pay attention to other factors, especially the price movement of the underlying asset.