Warrants and call warrants have been traded in Bursa for quite some years but are gaining more popularity in recent years. Some of the readers here probably noticed that I personally do invest/trade in some warrants and call warrants. Before some of you may be tempted to follow suit, I feel that I have a responsibility to share with you on the intricacies of these instruments and how I trade on them.
The article is fairly long so I have broken down into 2 parts. Part 1 will address the basics, including some of the terms and features we don’t see in shares and why warrants could be particularly attractive (using ekovest as an example). Part 2 I will share how I personally select warrants/call warrants (with one of my latest pick as a live example). Last time I tried to write some educational articles they are not very well received. So this round similarly if the reception for part 1 is poor, I will probably just stash part 2 away.
What is a warrant
Warrant is an instrument that is issued by the company that gives the holders the rights but not the obligation to exercise the rights by paying certain amount of money in exchange for certain amount of shares in the company. It is another term for option.
I know it sounds confusing for beginners, so just imagine the following situation.
A company ABC which has 100m shares trading at RM1.50 per share, issued 10m warrants, ABC-WA. ABC-WA has an exercise price of RM1 and exercise ratio of 1 to 1 with expiry date up till Dec 2020.
As ABC’s market price is higher than the ABC-WA exercise price, this is known as in the money option. What it means is if you hold one ABC-WA today, you can pay the company RM1 and get 1 ABC share worth RM1.50 anytime before the expiry.date. If unfortunately ABC shares drop below RM1, then ABC-WA is considered out of money.
So assuming now ABC is RM1.50, to pay RM1 and get RM1.50 worth of shares, sounds pretty good, isn’t it? Of course, market is not that foolish. The difference of RM0.50 (RM1.50-RM1.00) is most likely the minimum floor price for ABC-WA. Chances are ABC-WA is currently trading at above RM0.50.
Why would I pay more than RM0.50?
Previously the RM0.50 is the intrinsic value of warrant. If it falls below RM0.50, say RM0.40 technically there is an arbitrage opportunity where you can pay RM0.40 + RM1 to get RM1.50 worth of ABC shares. However, there is another part of warrant value which is the premium.
Let’s say ABC-WA is now trading at RM0.60, some people may wonder why would you pay RM0.60 for ABC-WA + RM1 exercise price to get RM1.50 worth of ABC shares? Essentially you are paying RM1.60 for RM1.50 worth of shares, or a 6.7% premium.
That premium you pay is for
i) Leverage or delta (potentially higher returns than buying ABC)
ii) Time value or theta (still easily 3.5 years before it expires)
iii) Volatility or vega (if ABC is a more volatile stock, warrant premium is likely higher, vice versa)
I will illustrate these in detail in an example below.
So what can you do with warrants?
You have two choices if you own a warrant, keep it or exercise it. Keep it, and the price will move in tandem but not identical to the mother share. Exercise it, and you will get the mother share and thereafter you are owning a stock.
What is a call warrant?
Call warrants, unlike company warrants, are issued by investment banks. The call warrant trade just like a company warrant with an exercise price, exercise ratio and expiry date fixed by the investment bank.
However, these call warrants do not give you the entitlement to exercise the warrant in exchange for mother’s shares. If you hold until expiry and the option is in the money (market price of mother>exercise price), you can get the difference but if it is out of the money, you get nothing.
Imagine an investment bank issued a call warrant, ABC-CA also at an exercise price of RM1 and exercise ratio of 1 for 1 and expiry date of Dec-17. If you buy ABC-CA, unlike ABC-WA, you cannot pay RM1 and get an ABC share in return. You can only sell ABC-CA, hopefully at a profit, or wait until expiry for settlement. If ABC is still trading at above RM1, you will be paid RM0.50 by the investment bank. If ABC is at RM0.99, you get nothing. The entire process does not involve ABC company and ABC is not responsible for any call warrants traded in the market.
Common features of warrant/call warrant (which are different from shares)
1. Expiry date
All warrant or call warrant has an expiry date, meaning it is worthless past that date, unlike shares which is traded forever unless the company is delisted or bankrupt. Warrants typically has expiry date of 3-5 years, some up till 10 years from issue date and is fixed by the company. Call warrants typically has expiry date of below 12 months and is fixed by the investment banks.
2. Warrant premium
I already explained above why a premium exists. If you buy a warrant and hope to exercise it, your effective cost is likely to be higher. There is a possibility that warrants can trade at negative premium. A few possible reasons like there may be an upcoming dividend (warrant holders are not entitled to dividend) or market is expecting the mother share to fall.
3. Different entitlements
Warrant holders are not shareholders, so warrant holders are not entitled to dividend until they exercise their warrant and hold company shares.
However, if there is a special dividend, capital repayment or corporate exercise like bonus issue, share split, then warrant exercise price and exercise ratio will be adjusted based on a set formula. Details of which I will not touch here.
A high return high risk instrument – Ekovest real life example
I noticed Ekovest last September when they proposed to sell Duke highways to EPF. So imagine if you invested in Ekovest on 30 September 2016 at closing price of RM1.91, it subsequently paid RM0.03 dividend and RM0.25 special dividend and did a 5 for 2 share split. At 31 March 2017, closing price was RM1.43. So an investment in 100 Ekovest shares at RM1.91 (RM191) will get you 250 shares worth RM1.43 (RM357.50) plus RM0.28 dividend (RM28), a total return of 102%.
But if you had instead invested in Ekovest-WB. Investment in 100 Ekovest-WB at 0.94 (RM94) back in 30 Sept will get you 250 Ekovest-WB at RM1.15 (RM287.50) with no dividend, a total return of 206%.
For Ekovest-WB holders back then, they would also probably experienced a period of time when Ekovest-WB premium shrinking until it traded at negative premium after the company proposed a special dividend. This is market pricing in the dividend and the fact that Ekovest-WB holders are not entitled to it. Because of the special dividend and share split, the exercise price and exercise ratio are also adjusted accordingly.
But now on the flip side. If you have invested in Ekovest and Ekovest-WB on 31 Mar 2017, what would be your return now? 100 Ekovest shares at RM1.43 (RM143) is worth RM1.22 (RM122) on 31 May 2017, a negative return of 14.7%. 100 Ekovest-WB at RM1.15 (RM115) is worth RM0.915 (RM91.50), a negative return of 20.4%.
That shows you the inherent risk and reward of investing or trading in warrants, which is why it is often called a double-edged sword. Mother price goes up, warrant goes up more, vice versa.
To be continued in part 2…
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wow u have explained it so well ... so easy to understand !! well done
really great effort. in simple language for everyone to understand.. appreciate it.. keep it up
Hi Jay, first time reading articles prepared by you and a newbee in investing. Good write up and easy to understand. Hope you will post the 2nd part to the article as well. :)
just a few more sifu like jay...i3 will become truly intelligent
Appreciate an resourceful and easy to understand article,from JAY.
Big Thanks !
Nice article for beginner in warrants...
I have a beginner question. If I hold call warrant until expiry and the option is in the money, what should I do to get return/money from investment bank? Or the return will be auto bank in to my account?
from what I understand, most IBs are still old school. they will send you a cheque by post
Very nice article and looking forward for part 2.
Thank you very much jay
Well done and thank you for sharing!
Thank you for sharing...looking forward to the part 2.
its better not to know than to know....especially the call warrants.
who can answer my question,
warrant type is call,
exercise price is 8.8,
exercise ratio is 8:1,
ABC-C44 warrant is 0.345,
ABC share now is 11.00,
i buy 0.345*8=2.76 for buy the ABC share in (8.8+2.76)=11.56
Happyleroy you have not given the expiry date of the warrant. You need to buy 8 warrant to be entitled to exercise your option by paying 8.80 to receive the mother share at expiry. That means your cost will be 11.56 for 1 share of ABC. If ABC share drop below 11.56 at expiry you will be out of the money. Am I right? You will only profit if the mother share price goes above 11.56.
Call Warrants can be sell before exercise date or not.
call warrants are ticking time bomb...
If Mother share issue share bonus, the call warrant exercise ratio and value will adjust also?
thanks so much jay ... appreciate greatly the effort !