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Warrants / Inline Warrants
Getting started

When you talk about warrants, what do you think of the first time? In the hope of throwing out a minnow to catch a whale? Become wallpaper after expiry date? These piles of plausible answers are simply not the best description of warrants.

Warrants are not new in the Hong Kong investment market. Since the re-opening of the warrants market in 2002, the number of warrants has increased. However, some retail investors still lack knowledge about the nature and risks of warrants.

Warrants are one of the derivative products. Warrants are an investment product which gives investors the right but not the obligation to buy or sell the underlying asset at a pre-set price on or before a specified date with leverage factor. ELI, CBBCs, futures and options are some commonly traded derivative products.

There are a lot of derivative products in Hong Kong market, but the most popular ones must be warrants. The daily turnover of warrants in Hong Kong is one of the highest in the world

Warrants are complicated, high-risk investment product suitable only for investors who are able to understand and grasp the product features and take the risks. There is still a lot about trading know-how. Find out more in the below paragraph.

Getting Started 1: What is a warrant?

Investors usually gain profit from rising stock prices. However, when stock price falls, unless investors take the short-selling method, it is difficult to gain profit from price falling. However, after the emergence of warrants, it provides an alternative to investors in lieu of traditional investment tools.

Warrants are an investment product which gives investors the right but not the obligation to buy or sell the underlying asset at a pre-set price on or before a specified date with leverage factor.

Warrants have a leveraged factor. Leveraged products seek to deliver a daily return equivalent to a multiple of the underlying assets. If you go in the right direction, you will be able to increase your profit and bring more returns. But if you go in the wrong direction, losses will be expanded by the leveraged factor. The leverage factor can be seen as a double-edged knife. As for the warrant price, it is affected by many factors, including the relevant asset price, investment period, exercise price, implied volatility, market interest rate and dividends.

Getting Started 2: Call VS Put

One of the differences between buying warrants and stocks is that warrants can be call or put warrants. A call warrant gives you the right to buy the underlying asset. A put warrant gives you the right to sell the underlying asset.:

Call Warrants -> an investor who believes that the price of the underlying asset will increase during the term of the warrant.

Put Warrants -> an investor who believes that the price of the underlying asset will decrease during the term of the warrant.

In-the-money and out-of-the-money: In-the-money and out-of-the-money

In addition to distinguish between call and put warrants, it is also necessary to understand what is meant by in the money, at the money or out of the money, which is a reflection of their intrinsic value.

The intrinsic value is the difference between the exercise price and the current price of the underlying stock.


Relation with Exercise priceRemarks
In the money

Call Warrants:Current price of underlying asset> Exercise price

Put Warrants:Current price of underlying asset<Exercise price

In general, the risk of “In the money” warrants is lower than “Out of the money” warrants, while the leverage factor is also lower. Warrants can be exercised at the expiry date. Price of the warrant contains their intrinsic value.
Put Warrants(At the money)Current price of underlying asset=Exercise price- -
Out of the money

Call Warrants:Current price of underlying asset<Exercise price

Put Warrants:Current price of underlying asset> Exercise price

The risk of “Out of the money” warrants is higher than “In the money” warrants, while the leverage factor is also higher. Price of the warrant contains time values only but not their intrinsic value. The price will become zero at the expiry date.

Getting Started 4: Underlying assets of Warrants

A warrant is a derivative product. It does not exist independently and its price often changes in relation to one or a basket of underlying assets. The underlying assets of the warrants trading in the Hong Kong Stock Exchange are mainly classified into four categories: indices, stocks, exchange-traded funds (ETFs), commodities and foreign exchange. Indices and stocks warrants are most popular in terms of quantity and turnover rate.

This list of eligible single Hong Kong stocks for derivative warrant issuance will generally be published by the HKEX at approximately quarterly intervals.

The number of stocks eligible for derivative warrant issuance was less than 200 at the end of 2009. At present,

the number of stocks eligible for derivative warrant issuance gradually increased and became more diverse.

Samples of stocks eligible for derivative warrant issuance

Stocks
China Insurance CompaniesCHINA TAIPING(00966)
PING AN(02318)
PICC P&C(02328)
CPIC(02601)
China Life Insurance (02628)
China BanksConstruction Bank (00939)
Industrial and Commercial Bank of China (01398)
Bank of China (03988)
Hong Kong BanksHSBC Holdings (00005)
Hang Seng Bank (00011)
Bank of East Asia (00023)
Standard Chartered Group (02888)
BOC Hong Kong (02388)
China Property DevelopersChina Overseas (00688)
China Resources Land (01109)
Evergrande Real Estate (03333)
R&F Properties (02777)

Data as of the first quarter of 2011

Source: HKEx

Remarks: For details of the other stocks eligible for derivative warrant issuance, please refer to the HKEx website.

Samples of ETFs eligible for derivative warrant issuance
ETFTracker Fund (02800)
Anshuo A50 China (02823)
Mark Zhihu 300 (02827)
Hang Seng Index ETF (02833)
SPDR Gold ETF (02840)

Data as of the first quarter of 2011

Source: HKEx

Getting Started 5: Differences between Warrant and Stock

The relationship between a derivative warrant and its underlying asset is not directly proportional. According to the option pricing theory, apart from the exercise price, there are some other factors affecting the theoretical price of a warrant, including the underlying asset price, expected volatility of the underlying asset price, dividends expected to be paid by the underlying asset, interest rate and time to expiry.Assuming that other factors remain constant, the price of the warrant is theoretically affected by the underlying asset price.

For example, if the leverage factor of a Put Warrant is 5 and other factors remain constant, when the price of underlying stock rises by 1%, the theoretical price would rise by 5%. On the other hand, if the price of underlying stock falls 1%, the theoretical price of the warrant will fall by 5%.

In addition to the leverage factor, the entrance fee to warrant is generally lower than that of the underlying stock. Therefore, it is claimed that the warrant is a tool for using a little knife to saw down a tree (using little capital to make big profit).There is an opportunity to bring a better return (However, if you go in the wrong direction, loss will be increased).

Differences between Warrant and Stock

WarrantStock
Leverage FactorYesNo
Gain ConditionHave a chance to make a profit in both bull and bear marketMainly profiting from the bull market
Expiry dateYesNo
DividendNoYes
Investment periodFor short/medium term investment in generalFor medium/long term investment in general

Getting Started 6: How to buy and sell warrants?

The buying and selling of warrants are indifferent to stock transaction. They can be traded during the trading session of HKEx. Warrants are similar to stocks and traded in board lots. The board lot size of a warrant varies from 100 to more than 10,000 warrants per lot. Assuming that the price for a warrant is $0.2, where the board lot size is 10,000, the transaction amount is $2,000. The transaction fee is similar to that of the underlying stock, including brokerage commission, transaction levy imposed by the SFC and a trading fee charged by the Exchange, but no stamp duty is payable.

Getting Started 7: Settlement of Warrants

Warrants have an expiry date. Most of the derivative warrants in the market have a shorter life, ranging from 6 months to 2 years normally, although the current Listing Rules allow a maximum life of 5 years. Warrants are generally divided into European or American exercise style. The difference between the two is that Americans can exercise their warrants on any trading day during the investment period, while Europeans are subject to the expiry date. There are all European-style warrants traded on the HKEx, which are settled in cash and automatically exercised.

Warrants are mainly short and medium term investment tools. Most investors will not hold to maturity. However, if they are held to maturity, it will be settled as follows:

Call warrant:(Settlement Price * - Exercise Price) / Conversion Ratio

Put warrant: (exercise price - settlement price *) / conversion ratio

* The settlement price is the average closing price of the relevant stock on the five trading days before the expiry date of the warrant. For the index warrants, it is the five-minute average price on the expiry date of the relevant month.

The warrant expiry date is not the same day as the last trading day. The last trading day is the 4th trading day preceding the expiry day.It is the deadline for the trading the warrant.

Example: Suppose a warrant expires on Tuesday and its last trading day will be the previous Wednesday.

MonTueWedThuFriSatSunMonTue


Last Trading Day




Expiry Day

Getting Started 8: Different market conditions

Warrants are tools for capturing profits from all market conditions or individual stocks in the short and medium term. Investors usually hold a view on market conditions at a certain time, such as a bull, bear or stag, and then decide how to trade according to the market conditions. The following section describes how to use various types of warrants to match different market conditions.

Bullish -> Call Warrant

Situation :Expecting market conditions to rise sharply in the short term

If the market conditions are expected to rise sharply in the short term, it means that the period of holding the warrants is generally not too long, and the erosion of its time value is relatively minor in this case. Therefore, it is possible to consider a slightly out-of-the-money or at-the-money call warrant with a relatively short period of time (around three to four months), in order to capture the short-term rise of the stock market with a slightly higher leverage.

Situation 2: Expecting market conditions to rise in medium and long term

If you want to capture the mid- and long-term ups and downs, you can consider an out-of-money call warrant with a longer term (around five or six months or more) to reduce the effect of the erosion of its time value and hold the call warrant for a medium term to share the profit from the rise of price of the underlying stock.

Bearish -> Put Warrant

Situation 3: Expecting falling prices and typically shrouded in pessimism

Relative to the bull market, the bear market is usually shorter and faster. Therefore, the holding period of a put warrant is usually not too long. At this time, a slightly out-of-the-money or at-the-money short-term (around three to four months) put warrant can be considered to capture the short-term adjustment of the stock with relatively high leverage.

Stag market -> Struggling between bulls and bears

Situation 4: Expecting fluctuation in a specific range

If fluctuation is expected in a specific range, investors can consider trading both call or putting warrant. When the stock price reaches a resistance line, buying a slightly out-of-the-money put warrant, selling it at the support line and buying a slightly out-of-the-money or at-the-money call warrant can be considered to capture the fluctuation.

Other than choosing the corresponding warrant in accordance with market conditions, warrant can sometimes be used as an investment strategy. For instance, it can be used as a tool to hedge the risk of holding relevant stock, or when a stock price rises to a certain degree, lock the profit by selling the stock and buying a call warrant of the relevant stock with smaller amounts.

Getting Started 9: Inline Warrants

Please refer to the information provided bythe Investor and Financial Education Council* for details.

*You should pay careful attention to the Liability Statement section on the homepage of the website of The IFEC at"www.ifec.org.hk" when referring to information using this link.

Risks of Exchange Traded Derivative Products

Exchange traded derivative products are derivative products that are listed or traded on an Exchange (including, but not limited to, Futures Contracts, Options Contracts, warrants, callable bull/bear contracts (“CBBCs”) (“Exchange Derivatives Products”)). The risks include:

a)it is not possible to predict the liquidity of Exchange Derivative Products. The fact that the Exchange Derivative Products may be so listed does not necessarily lead to greater liquidity than if they were not so listed;

b)for Transactions in relation to Investments involving contracts or instruments which are traded on an Exchange, the risk of loss may increase if certain events (such as disruption of the normal market operations or conditions of the Exchange or Clearing House, suspension or restriction of trading certain contracts or instruments and/or other events which affect the closing out of such Transactions or the liquidating of the relevant positions) occur;

c)under certain circumstances, the specifications of an Exchange-traded contract or instrument may be modified by the relevant Exchange or Clearing House and such modification may have an adverse effect on your Investments;

d)in the event that an issuer becomes insolvent and defaults on their listed Securities, you will be considered as unsecured creditors and will have no preferential claims to any assets held by the issuer.You should therefore pay close attention to the financial strength and credit worthiness of the issuers;

e)uncollateralized Exchange Derivative Products are not asset backed.In the event of issuer bankruptcy, you can lose your entire investment.You should read the listing documents to determine if a product is uncollateralized;

f)Exchange Derivative Products often involve a high degree of gearing, so that a relatively small movement in the price of the underlying Securities results in a disproportionately large movement in the price of the Exchange Derivative Products. The values of Exchange Derivative Products are not fixed, but fluctuate with the market, which may be influenced by many factors, including changes in the economic and/or political environment. The prices of Exchange Derivative Products can therefore be volatile and may fall to zero resulting in a total loss of the initial investment.Further, the price of an Exchange Derivative Product may not match its theoretical price due to outside influences such as market supply and demand factors.As a result, actual traded prices can be higher or lower than the theoretical price;

g)Exchange Derivative Products have an expiry date after which they may become worthless.You must be aware of the expiry time horizon and choose a product with an appropriate lifespan for their trading strategy.In particular, the value of a derivative warrant will decay over time as it approaches its expiry date, therefore, derivative warrants should not be viewed as long term investments;

h)investors should be aware of the underlying asset volatility.Investors trading Exchange Derivative Products with underlying assets not denominated in Hong Kong dollars are also exposed to exchange rate risk.Currency rate fluctuations can adversely affect the underlying asset value, also affecting the Exchange Derivative Products price;

i)the Exchange requires all structured product issuers to appoint a liquidity provider for each individual issue.The role of liquidity providers is to provide two way quotes to facilitate trading of their products.In the event that a liquidity provider defaults or ceases to fulfill its role, you may not be able to buy or sell the product until a new liquidity provider has been assigned; and

j)some Exchange Derivative Products have an intraday “knockout” or mandatory call feature.Such Exchange Derivative Products will cease trading when the underlying asset value equals the mandatory call price/level as stated in the listing documents.You will only be entitled to the residual value of the terminated Exchange Derivative Product as calculated by the product issuer in accordance with the listing documents. You should also note that the residual value can be zero.Further, with Exchange Derivative Products, the issue price of an Exchange Derivative Product includes funding costs.Funding costs are gradually reduced over time as the Exchange Derivative Products move towards expiry.The longer the duration of the Exchange Derivative Products, the higher the total funding costs.In the event that such Exchange Derivative Product is called, you will lose the funding costs for the entire lifespan of such Exchange Derivative Product.You should refer to the formula for calculating the funding costs that are stated in the listing documents.

Please refer to the link below for Disclaimer of the above information.

(http://www.bocionline.com/en/home/disclaimer/index.shtml)

This article was written by boCI's equity derivatives team - BoCI Equity Derivatives Department.