Trading Warrants

Trading warrants are the securitised warrants that are traded like stocks in the Australian Stock Exchange (ASX). Trading warrants can be classified into two categories:

• Calls
• Puts

One of the positive things about trading warrants is that they are traded in ASX just like shares, which is not the case for futures and options. If you are one of those traders who look forward to take advantage of the short-term changes in price, warrants should be the ideal option to go for.

As trading warrants involve calls and puts, it is important for the traders to have clear understanding about these two terms and how they work.

What is a Call Warrant?

A trader usually decides to purchase a call warrant when s/he thinks that the underlying security will gain in value (price) over the lifetime of the warrant. The underlying security can be a currency, commodity, index or stock. It is to be mentioned that the call warrant grants a trader the right to buy the underlying security for a fixed price (termed as the exercise price) at a future date but this is not an obligation for the investor.

To have a clear understanding about the call warrants, let’s consider a scenario and see how traders can use call warrants in the stock exchange to minimise risks. Let’s say, Mr. X is planning to invest on the shares of ABC Corporation and the ABC shares worth about $25 at present. Now Mr. X is anticipating that the ABC shares will soon gain and the price will hit $30. This means, buying these shares will allow Mr. X to make a profit of $5 per share. However, the reality is that the stocks can actually slide too and can hit a value say $21. In that case, instead of making profit Mr. X will incur loss for this investment.

Now in order to minimise the possible loss, what he can do is purchase the ABC stocks through a Call warrant. The warrant may cost him $0.50 and will give him the right to purchase the ABC shares for the predetermined warrant term at $25 (which is a fixed price).

Now if in reality the ABC stock price does increases to $30, the warrant will worth $5 at least for Mr. X as the warrant gives him the right to purchase the share for $25 and sell it in the market again for $30 right away. Instead of trading the share in reality what Mr. X can do is, simply sell the warrant for $5 and make a profit of $4.5 (after subtracting the $0.50 purchase price).

However, the shortcoming of this concept is that Mr. X might find himself in trouble if the ABC losses value instead of gaining. Say for instance, ABC shares dropped down to $22. In that case no one is going to buy the warrant for $0.50 that comes with a strike price of $25 considering the fact that these shares are already available in the market for $22. Now if Mr. X anticipates that the share is not going to gain as it was expected at the first place, the best option would be to sell it as quickly as possible before the expiry date arrives. This is how he can actually limit the possible losses. As far as this particular warrant is taken under consideration, Mr. X cannot lose more than $0.50 for this trade. So he knows exactly how much his maximum loss can be for the ABC shares.

What is a Put Warrant?

As far as the Put warrant is taken under consideration, the opposite scenario will take place. In this case a trader purchases a put warrant anticipating that the price of an underlying share will go down and if the anticipation turns out to be correct, the trader will make profit out of it. However, the trader will lose the initial outlay if the price does not fall.

The put warrant comes with the similar type of opportunities like call warrants. But the basic difference is that the profitability of each trade is related to the falling price of a certain stock rather than price gains.

Let’s say for example, our Mr. X has bought put warrant for ABC shares at its $25 worth of value and it cost him $0.35. Now if the ABC shares drop down to $22, it will mean that the warrant will worth at least $3 since under the current circumstances, Mr. X can actually buy the ABC share for $22 and can sell it straight away for $25 by utilising the warrant. So in that case the profit is going to be (4-0.35) = $3.65.

However if the share price moves upwards instead of losing, the put warrant will become worthless as the traders will be able to sell the shares at a price higher than $25. Now if Mr. X can anticipate this, he should sell off his warrant as soon as possible before the expiry date arrives. Just like the call warrants, the risk involved with the put warrants is also limited to the amount Mr. X paid for the warrant which is $0.35 in this case.