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October 1, 2020

What is a warrant?

  Compiled by myLIFE team myINVEST September 7, 2018 843

Starting to feel at home in the world of investments? Then it’s time you learned a little more about derivatives. Today’s lesson is on warrants. Not the kind used by the police! We’re talking about a type of financial instrument. How do they work and how do they differ from options? myLIFE is on hand to tell you everything you need to know.

A warrant is an exchange-traded security attached to an option right. It gives its holder the right, but not the obligation, to buy or sell an underlying asset, i.e. a share, stock market index, bond, currency, commodity, etc.

Warrants and options: part of the same family!

Warrants belong to the same family as options and work in a very similar way.

Before you go any further, if you do not know how an option works, please take a look at our article: What is an option? Ready? Ok let’s go!

So, in exchange for payment, a warrant gives the investor the right, but not the obligation, to buy (call) or sell (put) an underlying security at a certain price (strike price) within a pre-agreed time period. In the case of a call warrant, the investment is profitable if the price of the underlying security exceeds the strike price; the reverse is true for a put warrant.

The investor’s gains or losses are determined by the difference between the price paid to purchase the warrant and the price received for its sale.

Just like for options, the price of the warrant is largely determined by the intrinsic value and the time value. The intrinsic value is the difference between the price of the underlying security and the strike price. The time value represents the possible changes to the price of the underlying security. The nearer the expiry date, the less the price will move.

The investor’s gains or losses are determined by the difference between the price paid to purchase the warrant and the price received for its sale.

What are the differences between warrants and options?

As we said earlier, warrants and options basically work in the same way. There are, however, some differences between these two types of financial instrument. The main ones are as follows:

WarrantOption
A transferable security with an attached right.A contract pertaining to an asset.
Created by a financial institution.Created by a market operator (a company which operates the business of a regulated market of financial instruments).
Of limited number.Number can be unlimited.
Cannot be sold unless owned by the investor.Can be sold short (i.e. when not yet purchased).
Trading often requires a minimum quantity (e.g. 100, 1,000 etc.).Can be traded as an individual unit.

Before diving headlong into speculative trading, you need to weigh up the pros and cons of exercising a warrant.

Advantages of a warrant

  • Diversifying your portfolio: purchasing a put or call warrant allows you to diversify your portfolio by investing globally and more cheaply in companies, indexes, currencies or commodities.
  • Leverage: just like options, warrants create leverage, i.e. any increase or decrease in the price of the underlying asset is multiplied. If the market moves in the way you have predicted, you can make significant gains.
  • Limiting risk: the price of a call or put warrant is only a small part of the value of the underlying asset. This means that the biggest risk you take is the amount you pay. Any loss is therefore much lower than it would have been if you had purchased the underlying asset itself.
  • Protecting your portfolio: warrants can also help you to protect your investments. If you expect the market value of your securities to fall, you can buy put warrants (an option to sell) in order to offset any losses. They are therefore a kind of insurance.

Risks of a warrant

  • Leverage: leverage might be an advantage, but of course it can also be a disadvantage because its multiplying effect can work both ways. Although the maximum loss is known in advance, any changes in the price can be doubled or halved in a very short space of time.
  • Time: as explained earlier, the time value directly affects the price of the warrant. The value decreases as the expiry date draws closer because the chance of a change in the price of the underlying asset goes down.
  • Volatility: this is the tendency of the price of the underlying asset to go up or down. The greater the volatility, the higher the price of the warrant because it is more likely that you can make a profit on it. Volatility can therefore offset increases or decreases in the price of an asset and negatively affect the price of the warrant.

Can warrants be an alternative to bonuses?

Even if you don’t plan to dive into the world of derivatives right away, you might just become the proud owner of a warrant through your job!

Warrants are taxed much less than a traditional bonus. This means companies can make use of them, but only under certain conditions…

You might have heard of a warrant plan. It is simply another way for a company to award bonuses to its employees. The advantage is that warrants are taxed much less than a traditional bonus. This means companies can make use of them, but only under certain conditions specified in the Luxembourg Circular of 29 November 2017 on share purchase option plan taxation.

As at 1 January 2018, warrants have been taxed only on 30% of their value (17.5% until 31 December 2017), provided that this applies only to senior executives as defined in Article L. 211-27.5 of the Labour Code, that the value of the warrants does not exceed 50% of their gross annual pay, and that the price of the warrant does not exceed 60% of the value of the underlying security/index. If these conditions are not met, the real value of the warrant will be taxed.

So now you know a little more about this exchange-traded security. If you are still unsure, remember that the important thing is to do your research so you know exactly what you are committing yourself to. If you want to invest successfully, it all comes down to you!