Until now we have looked at trading warrants from a conversion trader's point of view. This is not where our interests lie. We are going to become premium traders. This means that we are going to trade warrants on the ASX, looking for a rise in the value of their premiums. We will start with equity call warrants. From now on we will just call them call warrants.
Call warrants are available on 75 different shares that are listed on the ASX (as at September 2001).
Some shares only have one call warrant available while others, like the big banks and resource companies have several. At the time of writing NAB has 22 different call warrants available. They are offered by several different issuers, and they cover several different exercise prices, expiry dates and conversion ratios.
I have listed below in Table 2.1 the ten shares which I trade Call Warrants over.
Table 2.1 The Shares that I Trade Call Warrants Over
| AMP | AMP | ANZ Bank | ANZ |
| BHP Biliton | BHP | Commonwealth Bank | CBA |
| National Aust. Bank | NAB | News Corporation | NCP |
| Rio Tinto | RIO | Telstra | TLS |
| Westpac | WBC | WMC | WMC |
I trade the call warrants over these shares because the trading volume is usually very good.
There are three terms that we need to know about when trading warrants, as they effect the way the price of the warrant reacts to the price of its underlying share.
Out-of-the-Money
A call warrant is said to be 'out-of-the-money' when the price of its underlying share is less than its exercise price. See Table 2.2 below, it's based on the example warrant NABWAB.
Our example warrant NABWAB has an exercise price of $30.00. Whenever the price of NAB is below $30, NABWAB is said to be out-of-the-money.
At-the-Money
A call warrant is said to be 'at-the-money' when the price of its underlying share is equal to its exercise price.
Our example warrant NABWAB has an exercise price of $30. Whenever NAB shares are priced at $30, NABWAB is said to be at-the-money.
In-the-Money
A call warrant is said to be 'in-the-money' when the price of its underlying share is greater than its exercise price.
Our example warrant NABWAB has an exercise price of $30. Whenever the price of NAB is above $30, NABWAB is said to be in-the-money.
Table 2.2 Call Warrant Trading Terms
| Underlying Share Price | Call Warrant Trading Terms |
|---|---|
| $25.00 | Deep Out-of-the-money |
| $29.00 | Out-of-the-money |
| $30.00 | At-the-Money |
| $31.00 | In-the-Money |
| $35.00 | Deep-in-the-Money |
This example is based on the call warrant NABWAB which has an exercise price of $30.00.
A warrant's premium is the price that we paid to buy it. The price of the premium follows the price of the underlying share closely. It is made up of two different values, Time value and Intrinsic value. It is necessary to know how these values are calculated, so that we can choose the most suitable warrants to trade.
WARRANT PREMIUM = TIME VALUE + INTRINSIC VALUE
The intrinsic value of a call warrant is the difference between the price of the underlying share and the exercise price of the warrant, divided by the conversion ratio of the warrant. If the difference is a negative answer then there is no intrinsic value.
In Table 2.3 below I have given some examples of the Intrinsic Value of NABWAB when NAB shares are trading at certain prices
Table 2.3 Intrinsic Value of NABWAB
| NAB Share Price | Intrinsic Value of NABWAB |
|---|---|
| $28.00 | No Intrinsic Value |
| $30.00 | No Intrinsic Value |
| $32.00 | $0.50 |
| $34.00 | $1.00 |
This example is based on the call warrant NABWAB which has an exercise price of $30.00 and a conversion ratio of 4:1.
NABWAB has an exercise price of $30 and a conversion ratio of 4:1. When NAB shares are trading at $30, NABWAB is said to be at-the-money. Its premium only consists of time value. It doesn't have any intrinsic value because its exercise price is the same price as NAB shares.
If the price of NAB shares were to rise to $32, then the premium of each NABWAB warrant would contain $0.50 worth of intrinsic value.
Intrinsic Value =$0.50
The Time value of a warrant is the difference between the price of the warrant (premium) and its intrinsic value.
TIME VALUE = WARRANT PREMIUM - INTRINSIC VALUE
We will work out the time and intrinsic values of NABWAB using real prices.
On the 10/07/01 NABWAB was priced at $0.84. NAB shares were priced at $32.30. Firstly, we need to work out the intrinsic value before we can work out the time value.
Intrinsic Value = (Underlying Share Price - Exercise Price of the Warrant) / Conversion Ratio of the Warrant
TIME VALUE = WARRANT PREMIUM - INTRINSIC VALUE
It is important to know that call warrants lose value over time. This is called Time Decay. The time value of a warrant is eroded away a little bit each day. When a call warrant is first issued, time decay is very slow. The closer the warrant gets to its expiry date, the quicker the time decay gets. A warrant will generally lose one third of its time value during the first half of its life span, and the other two thirds during its second half. We will look at this more closely below using NABWAB again.
On the 22/08/01 NABWAB was priced at $1.08. NAB shares were priced at $33.81.
Intrinsic Value = (Underlying Share Price - Exercise Price of the Warrant) / Conversion Ratio of the Warrant
TIME VALUE = WARRANT PREMIUM - INTRINSIC VALUE
Time Value =
In the space of about six weeks the time value of NABWAB has been eroded away by more than half. It is really important to understand that you only should hold call warrants while the price of the underlying stock is rising. Also, a warrant will lose value over the weekend. Even though no trading has taken place, time decay still keeps ticking away.
Time decay is also referred to as "Theta". If you see a warrant's theta quoted as 0.05, this means that the warrant will lose $0.05 in value each day. There are complex calculations used to work out a warrant's theta, but it is not necessary to know these. All that we have to be aware of is that time decay exists, and that the closer a warrant gets to expiry, the quicker the time value decays.
The Delta of a call warrant represents the change in value of a warrant compared to its underlying share. It can be presented as a decimal number between 0.00 - 1.00, or it can be presented as a percentage between 0% - 100%.
A warrant that has a delta of 1.0 (100%), means that if the value of the underlying share rises or falls by one cent, the value of the warrant will also rise or fall by one cent. A warrant that has a delta of 0.5 (50%), means that if the value of the underlying share rises or falls by one cent, the value of the warrant will rise or fall by half a cent.
The value of the delta rises and falls with the value of the warrant. If the price of the warrant's underlying share, is less than 70% of the warrant's exercise price, the warrant will have a delta of zero. When the warrant is at-the-money it will have a delta of 0.50 (50%). If the price of the underlying share is 30% greater than the warrant's exercise price, the warrant will have a delta of 1.0 (100%).
The other factor that effects the delta of a warrant, is the conversion ratio of the warrant. A warrant that has a conversion ratio of 1:1 has a delta range of 0.0 - 1.0. A warrant that has a conversion ratio of 2:1 has a delta range of 0.0 - 0.5.
Our example warrant NABWAB has a conversion ratio of 4:1. It has a delta range of 0.0 - 0.25. Therefore, if NABWAB was at-the-money it would have a delta of 0.125. If NABWAB was deep-in-the-money it would have a delta of 0.25.
It is important to remember that when you are choosing between different warrants to trade, warrants that are just out-of-the-money or at-the-money usually offer the best returns. Table 2.4 below shows how the delta changes as the price of the underlying share changes.
Table 2.4 Delta of a Call Warrant
| Underlying Share Price | Approximate Delta of a Call Warrant |
|---|---|
| 70% | 0.00 |
| 90% | 0.20 |
| 100% | 0.50 |
| 110% | 0.80 |
| 130% | 1.00 |
Price of the underlying share is expressed as a percentage of the warrant's exercise price.
There are a few other factors that can effect the premium of a call warrant. I will briefly describe them below.
Volatility
Volatility is the measure of the variation in price, of the warrant's underlying share, over time. It is usually displayed as a percentage from 0% - 100%. For example, if a warrant has a volatility of 31%, it means that the normal range of its underlying share's price is +31% to -31%. It is not necessary to know how to calculate volatility, only to know that it exists. If the price of a call warrant's underlying share rises by an abnormal amount, the volatility of the stock will increase, causing the premium of the call warrant to also increase.
Dividends
When the underlying share of a call warrant goes ex-dividend, the value of the warrant will decrease. Often, the dividend payment will be factored into the warrant's price several days before the underlying share goes ex-dividend.
To work out how much the warrant premium will fall by when it's underlying share goes ex-dividend, find out how much the dividend payment is and then find out the delta of the warrant. It is simply a matter of multiplying the dividend payment by the delta of the warrant. The answer should equal the amount that the warrant value will drop by.
Interest Rates
Interest rates can also effect the value of a call warrant premium. When interest rates are high call warrants are usually more expensive.
The purchase of a call warrant equates to a loan from the seller to the buyer, who may pay for their shares only at expiry. The higher the interest rate, the more the loan costs, so the call warrant becomes more expensive.
The trading volume of a call warrant varies accordingly to the present value of its underlying share and the value of its exercise price.
When a warrant is out-of-the-money there is little interest in it because the premium only contains time value. The warrant doesn't have any intrinsic value. As the warrant moves towards being at-the-money, the trading volume starts to pick up. When the warrant is at-the-money and moving into-the-money there is a big surge in the volume. This happens because the warrant has picked up intrinsic value and it is likely to be worth something in the future. The conversion traders start moving in. This is the best time to trade warrants. Buy them when they are at-the-money and the volume is starting to increase. Sell them when they move into-the-money and the volume is still strong. Also, the buy and sell spread is a lot closer on a warrant that is in demand. You will get a fairer price when you buy and you will have no trouble selling it for a decent price because of the strong volume.
This price and volume relationship is worth remembering because it helps us to choose the best warrants to trade.
Leverage (or Gearing) is a major factor in trading warrants. Leverage tells us, how much the warrant premium will rise (or fall), compared to a 1% rise (or fall) in the value of the underlying share. The answer is expressed as a percentage. It is also a useful way of comparing different warrants, to find out which ones offer better returns. Leverage is calculated as follows:
Leverage = (Underlying Share Price / Warrant Premium) x Warrant's Delta
Using our example warrant NABWAB, we will work out the leverage that it offered on the 10th September 2001.
Leverage = (Underlying Share Price / Warrant Premium) x Warrant's Delta
In the example above, NABWAB offers a 13.05% rise (or fall) compared to a 1% rise (or fall) in the price of NAB shares.
Another way of putting it is, buying $1000 of NABWAB warrants gives the same exposure as buying $13050 of NAB shares.
Warrant issuers are obligated to make a market for their warrants. This means that they are supposed to maintain a bid/ask spread for their warrants at all times. (Although there is no law saying how large or small these spreads should be.) Warrant issuers post a price matrix on their website, which states what their bids and asks will be when the underlying share is trading at certain prices. They also usually contain the terms of the warrant as well. See Table 2.5 below for an example.
In Table 2.5 there are three columns labelled Basis, Bid and Ask. These columns state what the bids and asks will be when the underlying share is trading at the price stated in the 'basis' column.
In our example NAB shares closed at $30.20. The issuer's bid for NABWAB at this level would be $0.325 and their ask would be $0.335. If NAB shares were trading at $30.50, the issuer's bid would be $0.37 and their ask would be $0.38.
NABWAB
| Warrant Type | Call |
| Exercise Style | American |
| Exercise Price | $30.00 |
| Expiry Date | 25-OCT-01 |
| Conversion Ratio | 4:1 |
| Delta | 0.1427 |
Table 2.5 Example Price Matrix for NABWAB
| Basis | Bid | Ask |
|---|---|---|
| $29.96 | $0.290 | $0.300 |
| $30.02 | $0.300 | $0.310 |
| $30.08 | $0.310 | $0.320 |
| $30.14 | $0.315 | $0.325 |
| $30.20 | $0.325 | $0.335 |
| $30.26 | $0.335 | $0.345 |
| $30.32 | $0.340 | $0.350 |
| $30.38 | $0.350 | $0.360 |
| $30.44 | $0.360 | $0.370 |
| $30.50 | $0.370 | $0.380 |
Information on warrant premiums and terms can generally be found on the website of their issuer. See the page Warrant Issuers for a list of warrant issuers and their websites.
I will now summarise the different factors that have an effect on the value of a call warrant.
| Underlying Share Price Increases | Call Warrant Premium Increases |
| Underlying Share Price Decreases | Call Warrant Premium Decreases |
| Time to Expiry Decreases | Call Warrant Premium Decreases |
| Volatility Increases | Call Warrant Premium Increases |
| Volatility Decreases | Call Warrant Premium Decreases |
| Underlying Share Goes Ex-Dividend | Call Warrant Premium Decreases |
| Interest Rates Increase | Call Warrant Premium Increases |
| Interest Rates Decrease | Call Warrant Premium Decreases |