What are options and warrants and how do they work?
Options and warrants are two types of the derivative contracts. Unlike most of the derivatives which are traded over-the-counter options and warrants are traded at an exchange. This makes options and warrants are unique to most of the other derivative financial contracts.
Both options and warrants allow the investor to hedge their exposure from the underlying markets. While options and warrants are commonly used together, they are very different from each other.
To explain this in very simple terms, the options are basically financial contracts. On the other hand, warrants are financial instruments. Despite this minor difference, both options and warrants are derivative products. One of the common factors for options and warrants is that they are used in stocks.
Warrants and options are similar in nature. They both have contractual rights to buy the stock of company at a price that is fixed in the contract for the specified period of time. Options and warrants are often thought and referred to as two different products. One of the reasons behind this misconception is that people refer to options as a compensatory service whereas warrants are seen as investment transactions.
Derivatives are nothing but financial instruments which do not have an independent value. On the contrary, derivative products get or derive the respective values from the underlying markets that they mirror.
Some examples of derivative products include futures and forwards, options, swaps and of course warrants. In this article we explain to you the difference between options and warrants and how each of these two products behave differently.
What are options contracts?
And option or an option contract is a type of derivative financial product the two parties engage in. In this contract the buyer of the option has the right but not the obligation to exercise their option. In other words, there is an optionality that comes with an options contract.
Options contracts are primarily used as a hedge against the actual market exposure. For example, you might be stock investor and have been holding a stock over a long period of time.
However, you might be concerned that the stock might lose in value over the next couple of months. Despite this risk you do not want to let go of the stock because it is already giving you good returns. In such a case, it would be easier for you to buy an options contract.
Options contracts are cheaper, and it allows you to buy the directionality after the underlying security. If you think that the price of the security will fall in a few month’s time, you can buy a PUT option. Put option allows you to speculate when the markets are declining.
On the other hand, if you think that the price of the underlying security will rise over a period of time, then you can buy a CALL option. A CALL option allows you to speculate when the markets are rising.
If you were wrong in your judgement, you can simply walk away from the contract. You are under no obligation to exercise the option. On the other hand, if you were right in your judgement, then you can exercise the option.
Option contract gives you the ability to use leverage when speculating in the stock markets. It is a lot cheaper to buy an option comparing to an outright purchase of the stock itself. Let’s illustrate this with an example.
Stock A is trading at $50 a share. You are interested to buy 100 shares. This means you will need a minimum capital of $5000. On the other hand, by making use of option contracts, you can get them a lot cheaper.
When you trade options, a single contract is equal to 100 shares of the underlying security. Depending on whether you want to speculate on the long side or the short side, you can purchase a CALL option or a PUT option.
The seller of the option also known as the underwriter charges you a premium. This premium is the only fee that you would have to pay when you purchase a CALL or a PUT option. Sometimes the premiums can be expensive, especially if the options contract is deep in the money. At the same time, option premiums can also be cheap if they are out of the money.
Typically, option contracts that are closer to expiry have higher premiums compared to the options whose expiry time is still far away. Within the many option contracts, when it comes to exercising the contract you have two ways of going about this.
An American option gives you the right to exercise your option any time up to the expiry of the option contract. On the other hand, a European option gives you the right to exercise your option only up on expiry or on the expiration date.
Going back to our example, a single option contract can be as cheap as $500. As you can see from the above comparisons, buying the stock outright is a lot more expensive comparing to purchasing the same number of shares via options. You can see that there are some clear benefits when you trade options.
If your speculation about the underlying index is proven to be wrong, you can simply walk away from the contract. On the other hand, if you purchased stocks, you would have to liquidate your positions at a much higher loss.
From the above example, we can see how options can help investors to manage their risk in the underlying markets.
Options are priced based on the intrinsic value and time value. The intrinsic value is the difference between the strike price and current price of the underlying security. Time value is nothing, but the amount of time left for the options contract to expire. Typically, option contracts which have longer time to expire have a great time value compared to the option contracts that are close to expiry.
Therefore, not all option contracts are priced equally.
Within the option contracts, you can also trade stock options or even currency options. Currency options also known as FX options are used by large companies who deal with import and export.
Because such companies are exposed to the fluctuations in the currency markets, FX options gives them a way to lock in a stable exchange rate.
What are warrants?
In finance, warrant is defined as a security which entitles the holder of the warrant to buy the underlying stock for which it was issued. Warrants can be purchased at a fixed price, which is also known as the exercise price, until the duration for which the warrant is valid. This is also known as the expiry date.
From the above definition, you can already see some similarities between the options and warrants. Both are no doubt, financial instruments that deal with the underlying stock. You can often find warrants issue to bonds or to stocks. In the stock market terminology, the shares that you get based on the warrants that you purchase are also known as preferred stock. A preferred stock is nothing but reducing the stock at a discount.
Although warrants are a type of certificates, they can be actively traded. In some stock exchanges, and especially in Asia, warrants are very popular financial products. The features that come with the warrant are very similar to have some derivative products work.
For example, you can exercise your warrant. You will also have to pay a premium when you purchased the warrant initially. Then, you also have the expiration date for the warrant, and the restrictions as well that apply. Warrants are also leveraged products.
Looking at the above features for warrants, one can easily mistake warrants to be similar to how option contracts work. Some academicians continue to debate weather warrants are financial derivatives or financial instruments. Depending on how you look at warrants, they can also be termed as longer dated options.
Similar to the choices you have with options in terms of exercising them, warrants also have the American or the European optionality. When a warrant is issued against the bond or a stock, they need to be registered with the exchange.
Warrants are also known as convertible financial instruments. This is because of the simple fact that when you purchase a warrant you can convert it into the underlying security if you want to.
Warrants are typically issued by private parties such as the corporations who have their stock listed. Because warrants are kind of derivative products and because they are also traded on an exchange you can find the price of a stocks warrant by simply adding “w” at the end of the ticker symbol.
There are different types of warrants which are more exotic some examples include:
• Traditional warrant
• Snail warrant
Stock warrants can be bought and sold with any broker as long as they specialize in this type of financial instrument. Remember that not all brokers offer trading on warrants. When you purchase warrants from your broker you are already dealing in the secondary market. This means that you are buying and selling warrants from another investor. Of course, that investor initially purchased the warrant from the company that issued it.
Similar to how bonds are trading in the secondary market, the yields and the price in the context of warrants can rise or fall. When you want to exercise your warrant, you would have to return it to the company. The company in turn, will issue new stock. You don’t have to go to the company in the literal sense. The broker from whom you bought the warrant will be able to exercise and convert the warrant into shares.
Because warrants are issued directly from the issuing entity, such as company, you can find more information about warrants by reading the annual reports. However not that not all companies issue warrants.
Differences between options and warrants?
So far, we have explained what are options, and what are warrants. In this next section, we will compare these two products to really understand how different they are.
An option contract gives the buyer the right but not the obligation to buy or sell the stock or the underlying instrument at the specified price on the expiry date
A warrant is a financial instrument that is registered and traded separately. A warrant gives the holder, the right to get a specified number of shares at a predetermined price and date.
And options contract is a contract.
A warrant basically behaves like a security
Option contracts are standardized instruments. Regardless of which exchange you buy or sell an option contract, you will get the same number of units.
Warrants are non-standardized instruments. They can vary depending on the issuing authority.
Option contracts can be bought and sold in the secondary markets as well. For example, if you purchased an option contract you would have to pay the premium to the seller. You can now sell your existing option to another buyer in the secondary market.
Warrants are primarily issued in the primary market. While there is also a secondary market for warrants, the liquidity is usually low.
Any investor can become an underwriter for an option.
Warrants are only issued by companies or other financial institutions.
Then an option is exercised in Leicester receives shares of the underlying index or stock from another investor
When you exercise your warrant, the shares that meet the obligations are given to you directly from the company.
When you exercise your warrant, the shares that meet the obligations are given to you directly from the company.
You can create warrants only on currencies, stocks and bonds
Options and warrants – Pros and cons
As with any financial product or derivative that you trade, there are pros and cons for trading options and warrants. Firstly, accessing such products is not that easy as compared to trading stocks outright.
Secondly, with the derivatives such as options and warrants it is not as simple as buying low and selling high. Options and warrants are firstly derivative instruments therefore they are used differently compared to trading of the actual underlying index.
Using products such as options and warrants investors can profit on the changes in the equity market price. These derivative financial instruments can also help you to manage your risk. One thing to note about options and warrants is that they are time sensitive. The contracts are only valid until they expire.
Besides being used primarily by investors as hedging tool, options and warrants can also be used by short-term speculators. However, the strategy that you need to use with such financial instruments, is a bit more complex and advanced compete to the regular buy and hold strategy.
Trading options and warrants is also very unique because while one investor might find the need to use these financial derivative products, another investor might not see the need for such instruments.
Options and warrants are less tangible compared to other investments. For example, if you wanted to get a loan from bank, you could use your existing stocks as collateral. On the other hand, an options contract is not used as collateral. This happens despite the fact that option contract gives the optionality to the holder of the contract to exercise their right.
Options and warrants – Conclusion
In conclusion, both options and warrants financial derivatives that are essential to the market structure. Both these financial derivative products have been designed to address a specific need for an investor.
At the same time the financial products mentioned above are designed as a way for companies to raise equity in the markets while giving some amount of flexibility for the investor purchasing these products.
The options and warrants I basically financially tools that allow the investor to invest in the stocks and various other financial instruments without having the need to hold the underlying security.
While they might look simple enough in design, they are very complex products. Therefore, trading such financial products requires an advanced level when it comes to dealing with the products and experience with the underlying financial markets.
The products were primarily designed to hedge risk. But at the same time if you do not know how to use these products is a good chance that you could end up losing money as well. Between the options and warrants, option contracts are a lot more easier to handle and transact and understand.
Many experienced traders make use of option contracts as a way to speculate in the financial markets. Because these products are leveraged, the amount of capital required is much less compared to traditionally holding the actual underlying security.
If you are interested to upgrade options and warrants, then it is highly recommended that you first get a good understanding of how these financial product work. The above article is outlined as a basic guideline to introduce you to how options and warrants work.