*** How to profit from trading warrants…

*** In, out or at the money - what it means for your trade...

*** A warrants trade explained... and more…

From the desk of Julie Brownlee

Dear Investment Academy Reader,

Before we leap into the profitable realm of warrants trading, I've got some exciting news...

Keep a look out for the new Fleet Street Publications' website launching next month. We're just adding the finishing touches. It's been completely revamped and includes loads of new functions that our current site doesn't offer you - such as ordering online! You'll even be able to access past issues of Investment Academy in our article archive. We'll let you know when it's online and you can go and check it out!

But, without further ado, let's get down to the nitty gritty of profiting from trading warrants.

Profiting from warrants

For the most part, people buy warrants as insurance. They either take a wait-and-see approach in a stock they're interested in by using a call warrant or they hedge against loss by buying put warrants. But big profits in warrants can also be made by buying and reselling the warrants themselves. The key is to find the right warrant at the right price (premium).

Where premiums come from

The premium of a stock warrant depends partly on its relation to the underlying stock. This is shown by the warrant's strike price as related to the market price of the stock at the time of the warrant purchase. If the strike price of the warrant is equal to the current market price, the warrant's considered "at-the-money".

A call with a strike price above the market price or a put with a strike price below the market value is considered "out-of-the-money". It's out-of-the-money because it would be worthless if it expired today.

For example, if you buy a Widget Co. 1100 call, but the price is 1000c, it's out-of-the-money. If you buy a NWBC 1150 put when the stock is at 1170c, it's also out-of-the-money, because you wouldn't exercise either warrant. After all, why would you want to pay 1100c for a stock when you could get it for 1000c? Conversely, why would you sell a stock for 1150c when people are willing to pay 1170c for it?

You buy an out-of-the-money warrant because you believe that, given the volatility of the shares and the time you're guaranteed until expiration, the shares will move above 1100c - and be in the money. That's when the call's strike price is below the current market price or the put's strike price is above the market price. The warrant now has intrinsic value - a calculable worth.

Obviously, in-the-money warrants usually have a higher premium than out-of-the-money warrants. But out-of-the-money warrants move far more rapidly in favour of the buyer, percentage-wise, than in-the-money warrants do when the underlying price moves your way.

At, in or out of the money

Calls:
Strike price = underlying instrument (at the money)
Strike price < underlying instrument (in the money)
Strike price > underlying instrument (out of the money)

Puts:
Strike price = underlying instrument (at the money)
Strike price > underlying instrument (in the money)
Strike price < underlying instrument (out of the money)

Extrinsic value

If warrant prices were based on their intrinsic value alone, there would be no reason to buy warrants other than for insurance or hedging purposes. A warrant's premium would be fixed. But beyond a warrant's intrinsic value is its extrinsic value, the worth of the premium represented by time and volatility.

Remember, warrants are wasting assets. They have a fixed term of life and die a little every day until they reach their expiration date. Unlike stock investors, warrant investors may not have time to recoup losses in a sudden turnaround. That risk can be reflected in the premium.

For example, say it's January and you're looking to buy more Widget Co. warrants. Currently the stock is at 2200c, and you think it'll go up to at least 2500c, but you're not sure when. Well, you could buy a March 2500 call, or a September 2500 call. Both are calls on the same stock at the same strike price, but the premiums could still be miles apart. Why?

A warrant has no intrinsic value unless it's in the money. For the Widget Co. 2500 call warrant to be in the money, it must go up 300c. Would you rather have three months (March) for the stock to go up 300c or nine months (September)? Most people would pick nine months and would buy the September 2500 call, but it depends on when you expect the price to move and how much you're willing to pay for the extra time.

Warrants are speculative investments and their value is as much a slave to supply and demand as just about anything you can buy and sell. Also, the more risk someone's willing to accept, the more they're going to want to get paid for it. (Think car insurance. Bad drivers pay more than good drivers.)

With more investors clamouring for the same warrant anything can happen in nine months; less is likely to happen in three, so you can expect the premium on the longer-dated warrant to be higher. Remember, the longer the time until expiration, the more time the warrant has to meet your profit target. That's less risk for you… and that means a higher premium.

In South Africa, the market makers, like Standard Bank, have as their main priority the provision of a market and will often concentrate on factors that make trading difficult, for instance volumes and volatility.

Making big money from warrants

A brief review: A warrant's premium, the price you pay for the warrant, is determined by several factors. There's the intrinsic value, based on the underlying stock price. This is pretty much set in stone. Then there's the extrinsic value: The time value, the volatility and the risk psychology. These can push the price of a warrant up or down significantly.

The secret: Buy a warrant when nobody wants it, then resell it when everybody seems to need it.

In short, find a cheap warrant on a stock you think is in for a big move, then buy it. When the move happens, the price of your warrant will move too. Your warrant will be in demand and investors will be willing to pay you for your warrant. If you sell, you have instant profits.

I'll use an imaginary example to show you what I mean

Imagine a company called Headbanger's shares are trading at 750c and you bought a warrant in the market to buy the shares at that price. In other words, it's an at-the-money call warrant with a strike price of 750. Let's say it cost you 25c.

Now imagine Headbanger releases sales figures that show that its new Gti sports model is taking the country by storm. The share price responds by suddenly going up 100c. The warrant will be worth more. Instead of the underlying share price being roughly the same as the exercise price of the warrant - 750c -  it's 100c higher.

This means you could exercise the warrant and make an instant profit by selling in the market - at 850c - the shares you're getting at 750c via the warrant.

What in fact happens is that the price of the warrant reflects the change in the underlying share price. So instead of being able to buy the warrant for 25c, its price might now be around 100c - to reflect the 100c rise in the price of the underlying shares.

So any percentage change in the price of the shares is usually magnified in the price of the warrants, usually around four or five times. In Headbanger's case, the price of the shares rose from 750c to 850c, or 13%. The price of the warrants rose from 25c to around 100c, a gain of 300%.

Although this process can work in reverse if the price of the underlying share falls, you have a strict limit on your losses. You can't lose more than the original cost of the warrant.

The big thing to remember if you're using warrants to speculate - as most warrant investors do - is that your judgement about the magnitude and direction of a change in price of the underlying has to be right. But that's not all. It has to be right within the timescale of the warrant.

It's no good being wrong at any time. But it's also no good being right about the price of a share if the move you expect happens after the warrant you've bought has expired.

Finding the winners

Of course, finding the right warrant takes work. Unfortunately, there's no easy way to teach you how to find these kinds of warrants on your own. You need to do your homework!

Warrant traders have their own statistical methods that work together to determine what they think a warrant should be worth. Delta is the hedge ratio that signals how warrants move in relation to the underlying share. Vega is the rate of change in volatility of the warrant. Theta is the change in premium per unit per time. These terms are called "The Greeks" on trading floors.

Now that you know what a warrant is and how they can bring you big profits, next week we'll see how you can go buy your first warrant.

Happy trading!

Julie Brownlee
For the Investment Academy