Trading warrants: How do they work and keys to understanding this instruments

In every discipline, understanding the broader picture, the correlation of various factors and the functioning of specific processes can be a challenging task. In most cases, this gets aggravated by a specific language and countless terminologies, not always used in a consistent and uniform way. While this hadn’t been much different in capital markets for the longest time, there has been some movement lately. While the number of asset classes, instruments or strategies has even increased and while factors affecting markets have become even more difficult to understand, the retail investor has advanced significantly, too.

A combination of circumstances has led to higher degree of retail investor sophistication and a growing trend towards self-directed financial investment in Europe. On the one hand, there is a generation of digital natives, who never had to overcome barriers in using digital applications as they’ve never been used to anything else. This has led to higher level of autonomy in every aspect based on digital information gathering and exchange. On the other hand, technological progress has made access to trading and investing easier to such an extent, that even older generations have put down their reservations. Technological leaps have always been playing a significant role in terms of enabling access to areas formerly restricted to select groups of participants in simplifying such access and making it cheaper. An often-overlooked factor though is the motivation for people to get engaged. While there are temporary trends, or hypes at times, decisive pattern changes are longer-term phenomena and mostly, they are economically driven. Be it the interest-rate environment, or longer-term considerations such as the uncertain future of national pension systems.

While certificates were established some years before, it was not until after the dot.com bubble burst that retail investors began looking into alternatives to an equity buy and hold approach and, respectively, how to protect their portfolios or even make profits when markets are falling. Two decades later, as we seem to have get used to one global scale crisis being superseded by the next and volatility has become a constant companion, retail investors searching for ways to optimise their income from trading activities has become the new normal. Certificates, particularly those with a leverage, are one such alternative.

History and categorisation

The most common generic term for structured retail products of that kind is securitised derivatives. The market in Europe emerged in the 1980’s with the first issuance of covered warrants in Germany and Switzerland, subsequently reaching France, Italy and the UK (today covered warrants represent just a small part of traded securitised derivatives). The European market for securitised derivatives can be broadly divided into Investment products, equal to 100% participation, and Leverage products. Through leverage products as for example warrants, the exposure is built towards the performance of an underlying asset with a higher degree of exposure than investing the same amount of capital directly into the underlying financial instrument or asset.

Investment products comprise capital protection products, yield enhancement products, participation products and credit linked notes whereas leverage products are divided into products without knockout, products with knockout and constant leverage products.

The most relevant markets for securitised derivatives in Europe are Germany, France, Italy, Sweden, Spain, Switzerland, The Netherlands, Austria, Belgium and the United Kingdom,

How do leverage products work

The price of a leverage product is determined by the price development of the underlying asset. While an option certificate’s price is also subject to the remaining maturity, the strike price and the degree of fluctuation of the underlying (implied volatility), leverage products such as warrants participate almost linearly in the performance of the underlying asset. Warrants, in turn, can come as products with or without knock-out.

The warrant’s leverage indicates by how many times the value of the warrant rises or falls, depending on how the underlying asset’s value changes with the leverage thus having a proportional effect on the value of the warrant.

Depending on which scenario a trader expects for the underlying, he or she may enter into a long warrant position – speculating on rising prices – or into a short warrant position if the expectation is that the underlying will decline in value. If the warrant is knock-out warrant, or turbo warrant, the leverage is disproportionate and can have a very positive effect on the profit. However, there is a risk, too, that the price of the underlying develops in the opposite direction than expected, beyond the so-called knock-out barrier, which means the knock-out warrant’s value will expire with zero value.

In order to calculate the value of a turbo warrant, the underlying, the subscription ratio and the knockout barrier must be known. The turbo warrant’s value can be derived from the difference between the price of the underlying and the knock-out barrier. The result is then multiplied by the subscription ratio. Then, the leverage will be calculated from dividing the price of underlying by the price of the turbo warrant and by multiplying this quotient by the subscription ratio.

Chances and risks

One of the most striking advantages of turbo warrants is that you only have to pay a fraction of the total value of your trade to open a position compared to a direct investment in the underlying. Then there is the chance of realising disproportionately high profit. In addition, through leverage products investors gain access to all major financial markets beyond stocks including commodities, indices, currencies and forex. Trading leverage products is the only way for retail investors to not just benefit from rising but from falling prices, too – thus effectively constituting the only way to enter into a hedge for a retail investor which is not possible without a derivative. It is also meanwhile very simple to trade leverage products adding to their popularity.

Then again, turbo warrants are suitable just for those investors who are aware and capable of bearing the inherent risks. Although it is possible to benefit disproportionately from price fluctuations, it is also possible to suffer a total loss of the invested amount. Even if this loss is capped at the amount invested through reaching the knock-out level and if you have invested less than you would have for buying the underlying asset directly, it remains a loss.

What should investors trading turbo warrants beware of?

Technological progress has led to significant behavioural changes among consumers. While people expect high levels of service, swift responses, flexibility, transparency, competitive prices and all this without time limits where possible, they should ask for this in trading to. This is not for the sake of being demanding but because there are significant differences between providers and the first thing investors should be sensitive about is on-venue trading. Getting their trades executed on a regulated trading venue means non-discretionary treatment of orders, a high level of transparency and the safety of an environment strictly monitored by supervisory authorities. Another very important aspect is the limitlessness of trading, i.e., the longer the trading hours, the better this especially for traders of securitised derivatives with knockouts. In trading turbo warrants, a high level of liquidity is disproportionately important, too, as you want to make sure that at upon every buying or selling interest, you’ll find the corresponding bid/ offer quotes.