The workings of warrants and options
May 28, 2004
By Laura du Preez
Warrants and options, like futures, are derivatives that derive their value from an underlying product, such as a share. This article is Part 49 in our Scrapbook Series.
Last week’s Scrapbook article explained that futures are agreements to sell a specified quantity of a particular item or asset on or before a fixed date at an agreed price. Options and warrants offer a slightly less risky alternative to futures.
Options and warrants give an investor the right, but not the obligation, to buy or sell a specified quantity of an asset at an agreed price, on a fixed date. In other words, they differ from futures in that the investor does not have to carry out the transaction or “exercise the option”.
For example, you may buy an option to buy 100 Anglo American shares for R130 on a particular day. If on that day the shares are trading for R120, you are unlikely to exercise your option.
However, if on that day they are trading for R140, you are likely to exercise you option, because you will be able to buy the Anglo shares at R130 and sell them on the market for R140, thereby making a profit of R10 on every share.
In order to buy the right to buy or sell the underlying asset, you pay a price, called a premium, to the seller of the warrant.
Options and warrants are less risky than futures, because if the price of the underlying asset moves the wrong way, you can walk away – you do not have to buy or sell. However, if you do not exercise your option, you will lose the entire premium you paid to get the warrant or the option.
The advantage of warrants and options is that they give you an opportunity to profit from price movements in the underlying asset or share – whether up or down – for a lot less money than it would cost you to buy the asset or share.
However, you should remember that although warrants, in particular, offer you a relatively cheap way to get exposure to shares, you do not become a shareholder of the underlying share by holding a warrant, and therefore you do not receive the dividends paid to shareholders.
The difference between options and warrants
Warrants are options to buy or sell shares that are listed on a stock exchange. The warrants themselves are listed on that stock exchange, rather than on the futures market.
The underlying asset of a warrant is always a share or a basket of shares, while the underlying product of an option could be anything from wheat to gold to shares.
Warrants are usually more accessible to the small investor, because the size of the contract, called the cover ratio, is smaller.
The cover ratio of an option or warrant is the number of options or warrants you need to buy one unit of the underlying asset. Warrants may, for example, only entitle you to buy a quarter or a half of a share, rather than one share or even 100 shares.
Warrants have no set time to maturity as this depends on the warrant issuer, but typically they are issued with an expiry date of four to 18 months. Options on the futures exchange usually have expiry terms – generally three months – that are set by the futures exchange.
Terms you should know
The price at which you have the right to buy or to sell the underlying asset is called the “exercise” or “strike” price, and the date by which you must buy or sell it is called the expiry or exercise date of the warrant.
You pay a price, called a premium, to the seller of the warrant in exchange for the right to buy or sell the underlying asset.
When the price of the underlying asset on the open market is the same as the strike price of the option or warrant, it is said to be “at the money”. If the share price moves up or down such that you would make a profit by exercising your option, the option or warrant is said to be “in the money”. If, however, the share price or price of any other underlying asset moves such that you would lose money by exercising it, it is said to be “out of the money”.
Types of warrants and options
There are two main types of options and warrants:
# A call option or warrant, which gives you the right to buy the underlying asset; and
# A put option or warrant, which gives you the right to sell the underlying asset.
If you think the price of a particular share is likely to rise, you should choose a call warrant giving you the right to buy the shares at a price close to their current price.
As the price of the share rises, your warrant becomes more and more valuable, because its price (or premium) also rises.
Once the share price rises above the strike price of your warrant, your warrant is said to be “in the money”, because you could make money by exercising it and then selling the shares at the market price.
For example, say you bought a three-month warrant on shares worth R100 000. Say the premium is R2 000. If the price of the shares on the market goes above R100 000 – your “strike” or “exercise” price – you are “in the money” because it will be worth your while to exercise your option, buy the shares and sell them on the market. If the price on the market falls below R100 000, you do not have to exercise the warrant and all you have lost is your initial investment of R2 000. If, on the other hand, you think the price of the shares is likely to fall, you could buy a put warrant, giving you the right to sell shares at a specific strike price.
As the price of the shares on the market falls, your warrant becomes more and more valuable. If the price drops below the strike price, you are in the money because you could sell the shares at the exercise price and simultaneously buy them on the market at a lower price.
Warrants may also be American-style or European-style. If they are American-style, they can be exercised any time up to the expiry date. European-style warrants can only be exercised on the expiry date, although the warrant can be bought or sold at any time before that date. Typically, call warrants issued in South Africa are American-style and put warrants are European-style.
The price of warrants and options
The price of a warrant and an option varies according to the price of the underlying share, or the “intrinsic” value, and the length of time the warrant or option has left to run. The “intrinsic” value of the warrant is the difference between the strike price and the price of the share or other asset on the market.
For instance, if you buy a call option on a share with a strike price of R160 and the price on the market is R200, you can make an immediate profit of R40, so the price of the warrant must be at least R40. This is the “intrinsic” value of the warrant and it drops to zero when the price on the market drops to R160.
But even if a warrant no longer has an intrinsic value, it can still have a “time” value. This is the value to you of holding the warrant for the rest of the specified period, during which time the price of the share on the market may rise above R160 again. You are paying for the possibility of future profit. The longer the time until expiry, the more expensive the warrant will be.
How to trade them
Warrants, like shares, can be traded through stockbrokers.
Prices are quoted daily in the JSE Securities Exchange lists in your daily newspaper and in Personal Finance on Saturdays.
At present about 260 warrants are available, some on individual shares such as Anglo American, Billiton, Nedcor, Sappi and Standard Bank, and others on indices. Warrants are issued by Deutsche Bank, Investec Bank, Standard Bank, Nedbank, Absa and Rand Merchant Bank.
The price or premium of warrants that have traded on the previous day are usually quoted in the financial section of daily newspapers.
When you buy a warrant, you not only pay the price of the warrant, but also brokerage fees, which vary but are usually about one percent or less of the value of your purchase, and Uncertificated Securities Tax, which is 0.25 percent of the value of the transaction, and a Strate charge, which also depends on the size of your transaction.
Options are traded on the futures market or over the counter in private deals between buyers and sellers.
