How a call warrant works

PUBLISHED : Tuesday, 12 October, 2010, 12:00am
UPDATED : Tuesday, 12 October, 2010, 12:00am

At its simplest, here's how a call warrant works. Say you want to bet that the share price of XYZ Corp, currently trading at HK$10, will rise. According to the terms of the deal, to bet on one share you have to purchase a minimum of 10 warrants. The strike price is HK$9. Each warrant costs 15 cents, so your total outlay is HK$1.50.

Say XYZ Corp's shares go up in value, as you hoped, to HK$12. That means the value of each of your warrants effectively doubles to 30 cents each - the current price of HK$12 less the strike price of HK$9, divided by 10 warrants per share.

There are two alternatives. You can either sell your warrants and pocket an effective return of 100 per cent. Or you can hold your warrants until they mature and hope the share price doesn't fall, then exercise your right to buy the stock for HK$9 and immediately sell it for a 30 per cent profit.

The downside of the trade is that if the stock price of XYZ Corp goes below the strike price of HK$9, then you lose your entire outlay of HK$1.50.

There are other risks as well. For instance, unless you actually want to purchase the underlying stock, you shouldn't hold your warrants until they mature. That's because the longer you hold onto the call warrant the less it is worth - something known in warrants parlance as time value.

Another caveat is that one of the peculiarities of the warrants market is the price of the underlying shares, and the warrants traded against them, don't always move in the same direction. Sometimes the share price goes up, while the warrants go down, potentially wiping out your investment.

Unlike equity warrants, which are often issued by a listed company itself rather than by an investment bank aiming to make a market in them, derivative warrants are structured and marketed by investment banks.