What are warrants?
What is a warrant?
A warrant is an investment product that gives you the right to buy (= call warrant) or sell (= put warrant) another financial product in the future. That might be shares, but could also be gold, commodities, currencies, index funds, you name it.
In addition to a predetermined purchase or sale price, a warrant always has a fixed term. Suppose you buy a warrant that expires in six months' time; you will automatically receive the proceeds of your warrant on the expiry date - at least, as long as your predetermined price is better than the prevailing price at that time. If it isn’t, your warrant simply expires.
How does the leverage effect of warrants work?
A key feature of warrants is their leverage effect. The easiest way to explain this is by using an example: suppose a share is worth 100 euros today and you expect its price to rise significantly in the near future. In that case it might be interesting to buy a warrant that gives you the right to buy, say, 20 shares at 100 euros each within the next six months. For the sake of simplicity, we will assume that your warrants cost 10 euros per share:
- If you buy 20 warrants at 10 euros per warrant, that means you invest 200 euros.
- If the share is worth 130 euros in six months’ time, your investment is suddenly worth 600 euros (a capital gain of 30 euros per share x 20 shares = 600 euros).
- So you make a profit of 400 euros (600 euros - 200 euros), in other words a return of 200%.
If you had used that same 200 euros to simply buy two shares instead of warrants, then after six months those shares would be worth 260 euros, giving you a 30% return. That’s also a very good return, of course, but is significantly less than 200%.
Note: This leverage effect also works in the other direction. If the price of the share price falls, say to 95 euros, your right to buy the shares at 100 euros each is then worthless and you have lost your 200 euros completely - whereas someone who initially bought two shares would only have lost 10 euros in value.
Why invest in warrants?
Investing in warrants has several advantages:
- The leverage effect mentioned above gives you the chance of achieving bigger returns with a small investment.
- The risk is limited to the amount you pay for the warrants.
- Investing in warrants gives you access to a variety of financial products and harder-to-reach markets.
- You can hedge against price falls, because put warrants mean you secure a fixed selling price for yourself in the future.
- You can add more variety to your investment portfolio with warrants.
What are the risks of warrants?
The risk profile of warrants can vary greatly from one warrant to another and depends on the following factors:
- There is no default risk for transactions effected on a regulated exchange. If you purchase warrants elsewhere, the creditworthiness of the counterparty will determine whether they will be able to pay out any proceeds to you.
- There is a moderate to high liquidity risk because the market for warrants tends to be smaller (there are fewer active buyers and sellers so it can be more difficult to sell warrants quickly and at a reasonable price).
- There is a currency risk when you buy currency warrants - though not if you buy warrants where the underlying assets are denominated in euros.
- The interest rate risk is moderate to high, depending on the term and structure of the warrant. Interest rate fluctuations affect both the price of the warrants themselves and the value of their underlying financial product.
- The price risk is moderate to high, as the price of the underlying financial product can cause the warrant to lose all of its value.
Interested in investing in warrants with Bolero?
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