RBS - Warrants, CBBCs and structural prducts

Quick Search

CBBC residual value search engine:

Residual value:

RBS Top Turnover CBBC

HSI Bull 62625

HSI Bear 61656

HSI Bear 61798

RBS Top Turnover Warrants

HSI Call 22537

HSI Put 23242

HSI Call 23240

Quick Links

RBS all focus products today

Moneyflow Analysis

CBBCs Outstanding Analysis

Knocked-out CBBCs

Warrant Thermometer

Headline Daily

RBS Newsletter

Newly issued warrants and CBBC

New Seminar

Underlying information

Derivatives Handbook

CBBC tutorial

Overseas related CBBC tutorial

Gold related warrant tutorial

Home > Education

What is a warrant

Pricing Factors

Terminologies

What is a warrant

What is a warrant ?

Buying a warrant is buying the right to purchase (for a call warrant) or to sell (for a put warrant) an underlying at a pre-determined strike price, on or by a pre-determined maturity date.

Making a decision to buy a warrant means you must have a view about the development of the price of the underlying.

COMPANY WARRANT:

If a company is issuing call warrants on its own stocks you speak about "Company Warrants". If these warrants were exercised, the company would issue fresh shares and deliver them to the warrantholder against payment of the exercise price. Why would a company issue company warrants? Because of the funding.

DERIVATIVE WARRANT:

"Derivative Warrants" are not issued by the underlying company but a financial institution in order to provide clients with an investment and trading tool. Don't be confused by the name. In Hong Kong , derivatives warrants are traded as cash products on the exchange, meaning that you only need a usual securities account to trade warrants.

We will focus on derivative warrants in the rest of this section.

	AMERICAN WARRANT:an American warrant can be exercised any time on or prior to the expiry date (or maturity date).
	EUROPEAN WARRANT:a European warrant can only be exercised on the expiry date (or maturity date).

Almost all listed warrants currently in Hong Kong are of European style. We will focus on European warrants in the rest of this section.

How to make Money out of Warrants ?

Holding the warrant until maturity:

Almost all listed warrants currently in Hong Kong are cash settled (therefore the investor saves the stamp duty). At maturity, you are entitled to a cash settlement amount calculated by taking the difference between the strike price and the "Settlement Price", divided by the relevant entitlement ratio. If the cash settlement amount is greater than your initial capital outlay, you make money by holding the warrant until maturity.

Example*：

On day one while the underlying is trading at $100, you invest $5,000 on 10,000 call warrants (@ $0.5 per warrant) with a strike of $100 and an entitlement of 10 warrants to 1 underlying. At maturity, suppose the settlement price of underlying is $110, you will be entitled to a cash settlement amount of $10,000, making a net gain of $5,000 or a return of 100%.

Initial investment on day one	10,000 x $0.5	$5,000
Cash settlement amount at maturity	10,000 x [($110- $100)/10]	$10,000
Net gain at maturity	$10,000 - $5,000	$5,000
Return at maturity	$5,000 invested, $5,000 earned	100%

The settlement price of a stock warrant is the average closing price of the underlying stock on the last 5 trading days prior to the maturity date.

The settlement price of an index warrant is usually the 5-minute average price of the index on the maturity date.

The settlement price of a currency or commodity warrant is usually taken from a specific price source at a specific time on the maturity date.

The cash settlement amount is usually transferred to the investor's securities account 2 to 3 business days after the maturity date. The formula of calculating the settlement price and the settlement details can be found in the related listing documents.

Trading the warrant before maturity:

Unless you have a particular investment objective, you don't have to hold a warrant until maturity. In fact, most investors choose to sell the warrants in the market before maturity. You may consider buying a call warrant if you are bullish on the underlying. As the underlying price goes up, you may sell the call in the market at a higher price. By the same token, you may consider buying a put warrant if you are bearish on the underlying. The price of a put goes up as the underlying price goes down. Profit is made out of "buy low, sell high".

Example*:

On day one, suppose the underlying is trading at $95. You are bullish on the underlying and you invest $5,000 on 10,000 call warrants (@ $0.5 per warrant) with a strike of $100 and an entitlement of 10 warrants to 1 underlying. One week later, suppose the underlying goes up to $99 and the price of the call goes up to $0.7. You sell the warrants at $7,000 and make a net gain of $2,000 or a return of 40%. In this example, the underlying ($99) is still trading below the strike ($100) but you manage to make quite a handsome profit. However, if the underlying was still trading below the strike at maturity, you would lose all your investment.

Initial investment on day one	10,000 x $0.5	$5,000
Warrant value after 1 week	10,000 x $0.7	$7,000
Net gain after 1 week	$7,000 - $5,000	$2,000
Return after 1 week	$5,000 invested, $2,000 earned	40%

In Hong Kong, the last day for you to buy or sell a warrant on the exchange is not the maturity date but the fourth trading day prior to the maturity date.

The lowest quoted price on the exchange for a warrant is HK$0.01. This doesn’t mean the price of a warrant cannot go below HK$0.01. This is in fact saying that it is not possible to get in or get out of a warrant at a price below HK$0.01. Effectively, the warrant is dormant until the price goes back up to HK$0.01 or above.

*The example is for illustrative purposes only and is not indicative of future returns.

Why buying a Warrant?

Below are some common reasons to buy a warrant:

Because of the leverage effect ─ A warrant magnifies the percentage price change of the underlying. Hence, you only need to pay a small portion of the underlying price for a similar or even bigger potential return. Be careful, however, that a warrant magnifies the potential percentage gain AND the potential percentage loss of the underlying.

Cash extraction ─ If an investor is holding some shares of a company, he may consider selling the shares, buying the call warrants with a small portion of the original capital outlay and using the remaining money for other things. By doing so, he remains similar exposure to the underlying share but the total risk is reduced by having less money in the market and more money in the pocket!

Protect the shares in the portfolio ─ Insure a stock portfolio with put warrants for a potential short-term market downturn. If the price of the share goes down the portfolio value decreases but the put value may increase and compensate for it.

Pricing Factors

Pricing Factors and Trading in Practice

At maturity, a warrant is worth its intrinsic value. There is intrinsic value only when a warrant is "In-The-Money" (meaning for a call, the strike is lower than the price of the underlying and for a put, the strike is higher than the price of the underlying). A warrant is worthless if it is "At-The-Money" (the strike is equal to the price of the underlying in the case of a call and put) or "Out-of-The-Money" at maturity (meaning for a call, the strike is higher than the underlying and for a put, the strike is lower than the underlying).

Before maturity, however, there is usually a positive value for an at-the-money or out-of-the-money warrant, and the price of an in-the-money warrant is usually higher than its intrinsic value. Why? Because as long as there is time left before maturity, there is still a chance that the warrant will end up (further) in-the-money at maturity. The warrant price therefore contains a time value portion which can be taken as a price tag to the remaining possibility.

As a warrant will always have a continuously changing price on the way approaching its maturity, there must be more things other than the underlying price influencing the warrant price.

5 FACTORS FOR THE WARRANT PRICE:

What happens out there?	What is the warrant terminology for this?	Effect on call warrant price	Effect on put warrant price
The spot goes up	Well, the spot goes up!	+	-
The lifetime of the warrant becomes shorter	Time decay	-	-
The price movements of the underlying are expected to get wilder	Implied volatility increases	+	+
"Goodies" being paid to the shareholders are higher than expected	Dividends increase	-	+
It's more attractive to put the money"in the bank"	Interest rates rise	+	-

1. Whether it is worth buying e.g. a call warrant is in fact deciding about the likeliness of the underlying trading at a price higher than the strike at maturity. The higher the spot price, the better chance the call will end up (further) in-the-money at maturity. That's why most people take it for granted that the prices of the underlying and the call warrant should always go in the same direction. But don't forget...

2. Time is money. Unfortunately time is always running against you as a warrantholder since the lifespan of a warrant is fixed. Over the lifetime of a warrant, the time value portion in the warrant price keeps decreasing ("time decay"). Time decay overnight is insignificant when a warrant has e.g. 6 months left, but time decay overnight could make a huge difference if there was only 1 week left before maturity for an out-of-the-money warrant. Time decay is an inevitable cost and the surest way to beat it is to have the underlying move in your direction, by an enough magnitude.

3. The magnitude brings us to the third factor - the implied volatility. An underlying that is expected to stay at about the same price all the way through seems boring. If it is very unlikely that the underlying will reach the strike at the end of the day because the underlying will not be moving a lot anyway, why should you pay for this warrant? That’s why volatility, or implied volatility to be precise, works hand in hand with the days left to determine the time value of a warrant. The more wildly an underlying is expected to swing, the more valuable its warrants. The reverse is true as well: if an underlying was losing expected volatility, the price of its warrants (both calls and puts) would be badly affected.

Don't be frustrated if you are confused, most investors feel the same way at the beginning. Just always remember, when you intend to buy a warrant, ask yourself: Which way do I expect the underlying to move? By what kind of magnitude do I expect it to move? And by when do I expect the underlying to move by that magnitude? And you should be less subject to a sudden burn.

The next two factors have less influence on the price of a warrant.

4. When a stock warrant is issued, the issuers will make reference to the dividend policy of the company or market expectation on future dividends of the company. The issue price of a call is "lowered" and the issue price of a put "raised" accordingly because of the expected dividends. As long as the actual announced dividends fall in line with the expected level, warrant price won’t be affected. But in some cases, if a company announced a special bonus or alike, the price of a call would be hurt and the price of a put would benefit.

5. Lastly, the interest rates. Buying a call warrant instead of the underlying saves you much capital outlay. You can put the saved cash in a bank at least to earn you interests. So it's easy to figure out why the price of a call goes up when the interest rates become (significantly) higher. On the other hand, a put warrant entitles an investor to a right to sell something in the future. The sales proceeds could have earned the investor some interests if he was selling that something outright. Therefore, the higher the interest rates, the less well-off a put warrant investor is.

TRADING WARRANTS IN PRACTICE

The above 5 factors mainly explain the movement in the theoretical warrant price. In practice, you need to pay equal attention to the forces of demand and supply, the outstanding quantity, the bid/ask spread, liquidity (to a certain extent turnover) and the quality of the issuer/liquidity provider. It is worth putting extra effort to compare the issuer quality because issuer plays an important role in balancing the forces of demand and supply. If there was an over demand for a warrant, price could be bid up to unreasonably high level (in technical terms we say the implied volatility is far too high compared to the market level). To the contrary, if there was an oversupply of a warrant, due to e.g. a sudden massive selling pressure, price could be driven down substantially. Hence, you may prefer a more trustworthy issuer so that there won’t be too much shock for you in warrants trading.

Below is a quick WARRANT CHECK LIST for you. It should take you less than three minutes but it certainly helps you to have the upper hand in the game.


	How do you expect the underlying to move? Do you have a target price? Do you have some idea of the resistance and support levels?
	Do you expect the underlying to move wildly, moderately or mildly? Quickly or slowly?
	Have you checked the distance between the strike price and the spot price? (Rule of thumb: go for 5% in-the-money to 5% out-of-the-money.)
	Have you checked the time left before maturity? (Rule of thumb: go for maturity of 3 months or more.)
	Check if the issuer/liquidity provider is actively offering a reasonably tight bid/ask spread, or if it is just the market that buys and sells the warrant. (Rule of thumb: you should expect to see an active liquidity provider and active market buying/selling at the same time.)
	Check the steadiness of the warrant performance (in technical terms the steadiness of the implied volatility). Is the warrant price jumping up or down by more than you expect most of the time? If yes, avoid it. There are so many choices in the market.
	Check the implied volatility of the warrant. Usually a lower implied volatility (compared to warrants of similar terms) means a cheaper buy. However, it doesn't mean the implied volatility can't go even lower. Therefore, look at both the level and the relative steadiness of the implied volatility.

Terminologies


	At-the-money	When the strike equals or is very close to the spot price of the underlying.
	Deep-in-the-money	When the strike of a call warrant is far lower than the spot price of the underlying (more than 15% in general) or the strike of a put warrant is far higher than the spot price.
	Delta	The price change of the warrant for a 1 unit movement of the underlying. The delta lies between 0 to 1 (adjusted by the entitlement) for a call warrant and 0 to -1 (adjusted by the entitlement) for a put. The absolute value of delta is also the probability that the warrant will end up in-the-money at maturity.
	Effective Gearing	The percentage change in the warrant price for a 1 percent movement of the underlying. Effective gearing is the product of delta and gearing and gives the investor an indicator of the potential risk/return.
	Entitlement	How many warrants you have to hold for the equivalent of 1 unit of underlying.
	Exotic warrant	Non-standard warrant with special features.
	Far-out-of-the-money	When the strike of a call warrant is far higher than the spot price of the underlying (more than 15% in general) or the strike of a put warrant is far lower than the spot price.
	Further issue	That issuer may apply to HKEx to issue more warrants of the same series if it is holding no more than 20% of the existing issue on the launch date of the further issue.
	Gamma	The movement of delta when the underlying moves. Gamma is an indicator of difficulty to hedge.
	Gearing	The ratio of the underlying price to the warrant price (adjusted by the entitlement).
	Hedging	That issuer buys and sells the underlying asset and related derivatives to reduce its risk.
	Implied volatility	The implied volatility is calculated by an option pricing model based on the market price of a warrant. It is an indicator of the relative value of warrants of similar terms. The lower the implied volatility, the cheaper the warrant relative to warrants of similar terms.
	In-the-money	When the strike of a call warrant is lower than the spot price of the underlying or the strike of a put warrant is higher than the spot price.
	Intrinsic value	The value of a warrant if it is exercised today. In terms of a call the price of the underlying minus the strike and in terms of a put the strike minus the price of the underlying (adjusted by the entitlement).
	Light Sweet Crude Oil (Light Sweet Crude Oil)	Specific crudes with low sulphur content and relatively high-value products such as gasoline, diesel fuel, heating oil and jet fuel. It is the world’s most actively traded commodity and the "crude" oil that is quoted most of the time.
	NYMEX Light Sweet Crude Oil Futures Contract	The world's most liquid futures contract trading on crude oil and the world's largest-volume futures contract trading on a physical commodity. Because of its excellent liquidity and price transparency, the contract is used as a principal international pricing benchmark.
	OTC	Over-the-counter. Privately negotiated deals between two parties off the exchange.
	Out-of-the-money	When the strike of a call warrant is higher than the spot price of the underlying or the strike of a put warrant is lower than the spot price.
	Outstanding quantity	The quantity of warrants held by the market (i.e. warrants not held by the issuer) at the end of a trading day. Outstanding quantity can also be expressed by the quantity of warrants held by the market as a percentage of the total quantity issued.
	Plain vanilla warrant	Standard warrant with no special features.
	Premium	How much in percentage terms the underlying has to move before the warrant expires in order of an investor to break even, if he is buying the warrant at the current price. The premium is more relevant only when an investor intends to hold the warrant until maturity.
	Rho	The change of the price of the warrant when the interest rates change by 1 percent.
	Theta	The price change of the warrant when time to maturity reduces by 1 day.
	Time value	The extra portion in the warrant price above intrinsic value.
	Troy ounce	Troy weight is the system of weights used for Gold, Silver and Jewels with 12 troy ounces in every troy pound. 1 troy ounce is equal to 1.097 ordinary ounce or 31.1034768 grams.
	Vega	The price change of the warrant for a 1 percent movement of the implied volatility.

© Reuters . The Royal Bank of Scotland N.V., incorporated in the Netherlands with limited liability. Registered with the Chamber of Commerce in The Netherlands, no 33002587.
The Royal Bank of Scotland N.V. is in certain jurisdictions an authorised agent of The Royal Bank of Scotland plc and The Royal Bank of Scotland plc is in certain jurisdictions an authorised agent of The Royal Bank of Scotland N.V.

By viewing this website, you acknowledge that you agree to the terms and conditions of this website.
Please read our disclaimer and privacy statement as stated .
The price shown are not real-time prices, i.e. they are delayed due to mandatory requirements of data provider.
© Copyright 2010. The Royal Bank of Scotland N.V. All rights reserved.