Alan Hull Articles

Exchange Trade Warrants - Part 1

Warrants are option contracts that are issued by financial institutions or approved warrant issuers and traded on the Australian Stock Exchange. Warrants can be issued over shares, Australian and overseas indices, commodities and currencies. Warrant markets exist throughout America, Asia and Europe. Warrants have been available in Australia since 1991 via the Derivatives Division of the ASX.

The volume of warrants traded within Australia has risen sharply since 1996 with rapidly growing retail investor participation. The warrant market now has greater liquidity than either the futures or options markets. This phenomenon can be attributed to two main factors; the warrant market provides issuers with a lot of flexibility and warrants are traded on the ASX SEATS system unlike futures and options which are traded on other exchanges.

Financial institutions issue warrants over shares to earn premiums that are paid by warrant holders. Warrant holders use warrants for leverage over share prices and to exploit downward movements in share prices.

Important Points
• In buying a warrant the holder buys the right but not the obligation to exercise the warrant at a future date.
• A warrant holder does not own equity in the underlying public company.
• A warrant holder has a contract with the warrant issuer and both parties are subject to the obligations as specified in the warrant contract.
• The ASX does not guarantee nor underwrite the obligations of the warrant issuer.
• Before trading warrants it is necessary to read the booklet "Understanding Warrants" and sign a declaration form, supplied by a Stockbroker.

How do Warrants Work?

The most commonly traded types of warrants are referred to as 'Call' and 'Put' Warrants. Call Warrants are used to trade upward movements in share prices whereas Put Warrants are used to trade downward movements in share prices. If you are trading Call Warrants you are going 'Long' whereas if you are trading Put Warrants you are going 'Short'. The following examples show how to interpret the 'Warrant Tables' contained in daily newspapers such as the Age and the Australian.

Example of a Call Warrant
Code	Exercise Price	Exercise Style	Expiry Date	Type	Ratio
TLSWMJ	8.00	American	29/06/2000	Call	3:1

• The code indicates that this is a Telstra warrant issued by Macquarie Bank and is warrant 'J' in their series.
• The exercise price is the amount that must be paid to the warrant issuer to exercise the warrant. If the share price of Telstra is below $8.00 it is said that the warrant is "Out of the Money". If the share price is $8.00 the warrant is "At the Money" and if the share price is higher than $8.00 the warrant is "In the Money". The exercise price is also referred to as the strike price.
• There are American and European style warrants. American style warrants can be exercised by the holder at any time up to and including the expiry date. European style warrants can only be exercised at the date of expiry. American style warrants are more common. Daily newspapers do not normally list warrant styles.
• At the expiry date the warrant must be exercised or it becomes worthless. Warrant issuers usually notify warrant holders several weeks prior to the date of expiry. The onus is on the warrant holder.
• The warrant can be either a Call or a Put warrant.
• The ratio sets the number of warrants that can be converted into a single Telstra share. A ratio of 3:1 indicates that 3 warrants are equal to 1 Telstra share.

  Numeric Example of a Call Warrant - Telstra (TLS) - $7.85
  Code	Strike	Expiry Date	Type	Ratio	Bid	Ask	Last	Vol(100s)
  TLSWMZ	8.00	29/06/2000	Call	3:1	29	32	30	2000

• With Telstra shares trading at $7.85 this warrant is 'Out of the Money' and has no intrinsic value.
• Market participants are prepared to pay 30 cents for this warrant because of future expectations that the share price of Telstra will rise. This cost component of the warrant is known as the premium or time component. If the share price of Telstra was to remain at $7.85; the premium component will reduce with the passage of time to zero.

  Numeric Example of a Call Warrant - Telstra (TLS) - $8.24
  Code	Strike	Expiry Date	Type	Ratio	Bid	Ask	Last	Vol(100s)
  TLSWMZ	8.00	29/06/2000	Call	3:1	35.5	38	36	2400

• With Telstra shares trading at $8.24 the warrant is now 'In the Money' and has an intrinsic value of:
  (8.24 - 8.00) ÷ 3 = 8 Cents
  Intrinsic Value = (Share Price - Strike Price) divided by the Ratio
• The premium component = Warrant price - Intrinsic Value
  36 - 8 = 28
  Note that the premium component of the warrant price continues to fall even though the share price and warrant price have increased. If Telstra's share price remains above $8.00 (ie. In the Money) the premium component will still reduce to zero and, at the date of expiry, the warrant price will equal the intrinsic value.

  Example of a Put Warrant
  Code	Exercise Price	Exercise Style	Expiry Date	Type	Ratio
  NABWFP	25.50	American	23/09/1999	Put	4:1

In the case of a Put Warrant it is 'In the Money' when the share price of National Australia Bank (NAB) is less than $25.50 and 'Out of the Money' if the share price is higher than $25.50. Hence the value of the warrant increases as the share price of NAB falls. By purchasing a Put Warrant the holder is entering a contract with the warrant issuer which gives the holder the right but not the obligation to sell NAB shares at their current price with the expectation of buying NAB shares at a lower price when the warrant is exercised. The following chart shows how a Put Warrant behaves compared to the actual share price.

Important Tip

There is a psychological resistance to going 'Short' amongst Australian Traders and Investors. It is seen as profiting from someone else's demise. As a result of this psychology Put Warrants suffer liquidity problems and provide reduced leverage as compared with Call Warrants. They are said to be sluggish. Traders usually buy Put Warrants that are 'In the Money' and have an intrinsic value component.

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