Exchange-Linked Warrants

Exchange-linked warrants (ELWs) are used by traders to speculate on the future price movements of underlying assets and to hedge against other positions. This tutorial explains how exchange-linked warrants work, from their structure and history to risks and limitations. Our team have also reviewed and ranked the best brokers with ELWs:

Warrant Basics

A warrant gives the holder the right but not the obligation to purchase or sell the underlying security (usually a stock, index, commodity or currency) at a specified price (strike price) on a specified date (expiry date).

American warrants allow holders to exercise the warrant before the expiry date, whereas European warrants can only be exercised on this date. A call warrant is the right to buy the security and a put warrant is the right to sell it.

Stock exchange-linked warrants are often used as a way for companies to raise capital. Companies issue the warrants and, in return, they receive the cost of the warrant (the premium) from investors. Should the warrant then be exercised, the company receives the value of the share purchase.

Although the traditional way of issuing shares raises capital for companies, warrants can be more attractive to investors – their cost is usually lower than the cost of the underlying share and they are also leveraged, meaning that their value can move faster than the value of the underlying security. Although this could lead to higher losses, it also means traders can profit more from a given amount of capital.

Exchange-Linked Warrants

Exchange-linked warrants are a type of warrant that trade on an exchange and are linked to securities that trade there. ELWs can be found on major global exchanges like the New York Stock Exchange (NYSE) and the London Stock Exchange (LSE). Included under the umbrella of ELWs are equity warrants, index warrants, commodity warrants and FX-linked warrants.

Traders should also be aware of the difference between cash-settled and stock-settled warrants. With cash-settled warrants, the profit is received directly on the expiry of the contract. Share-settled warrants result in the exchange of shares when the contract expires. This is often on a 1:1 ratio (one warrant to one share) but different ratios may be stated.

Cash-settled warrants are often a suitable option for traders wanting to simply speculate and profit on price movement rather than take ownership of shares.

Warrants Vs Options

Although there are similarities between the two products, there are also some fundamental differences. Stock warrants are usually issued by the business. If the warrant is exercised, then the shares are also issued by that company – it is essentially an agreement between the trader and the business.

Options, on the other hand, are an agreement between two traders where the shares are exchanged between the traders and the company usually has no involvement.

Another difference is that options are usually active for a shorter period. Whereas options may have a few months until expiry, exchange-linked warrants can have several years – sometimes even as long as 15 years.

History

Warrants originated in the 1920s with stock warrants being issued by large companies such as Ford Motors and General Motors. They have since expanded to markets across the world as more companies attempt to access global liquidity.

Today, warrants are relatively popular in countries like the UK, Canada, and Germany.

How Exchange-Linked Warrants Work

The strike price of an exchange-linked warrant is important – it determines whether the holder makes a profit or not. The strike price is usually above the underlying asset’s current value when the exchange-linked call warrant is issued. If the market price of the underlying asset is above the strike price at the point when a call warrant is exercised and the gap exceeds the premium then the investor will make a profit.

If the market price drops below the strike price when the warrant expires, then the trader would not exercise the warrant and, instead, simply lose the premium they paid. Essentially, if traders think the price of the underlying asset will rise in value, they should purchase a call warrant – if they think it will fall, they should purchase a put warrant.

It is important to note that when a trader buys a warrant, the most they can lose is the premium. The fact that there is certainty over potential losses is one of the main benefits of purchasing exchange-linked warrants.

Remember that warrants can drop sharply in value and become almost worthless, depending on the value of the underlying asset relative to the strike price and time to expiry. The more likely it is that the strike price will be met within the set period, the higher the value of the warrant.

Exchange-linked warrants can be bought and sold on the secondary market before they expire.

Example

Suppose Company X offers warrants for £3 each. The current share price of Company X is £10 and the strike price of the warrants is £15. A trader has seen that the long-term growth prospects of Company X look positive and thinks that its share price will rise. They purchase 100 call warrants at a total cost of £300. The ratio of warrants to shares is 1:1.

Scenario 1

The share price does increase as the trader expected to £25. The trader can purchase shares worth £2,500 for only £1,500. The difference is, therefore, £1,000.

After the premium and any other brokerage costs, the profit will be around £700.

Scenario 2

Unfortunately for the trader, the share price of Company X stays at £10. As this is below the strike price of £15, the trader does not profit and instead loses the £300 that they paid for the exchange-linked warrants.

Characteristics

As mentioned previously, exchange-linked warrants can have different underlying assets.

Equity Warrants

Equity warrants are also known as stock-linked warrants. They are pegged to the price of a particular stock and companies use them as a way to make it more desirable for investors to purchase their shares.

These types of warrants may also be listed as part of a corporate bond sale. In these cases, a premium is not always paid for the warrant, instead, the investor has to accept a lower interest rate on the bond.

Index Warrants

Index-linked warrants track the price of a particular index, such as the FTSE 100 or S&P 500. They are generally cash-settled (as it is not possible to buy actual shares in an index).

In addition to them being used to speculate on the future value of the index, index-linked warrants may be used to hedge against an existing position. For example, an investor may also have an ETF that tracks the S&P 500. If the future of this index is uncertain, for example due to global economic headwinds, the trader may wish to purchase exchange-linked put warrants that track the same index, helping to reduce losses if its value decreases.

Currency Warrants

Currency-linked warrants give the holder the right to enter a position at a predetermined exchange rate (the strike price) at a specified point. The mechanism operates similarly to stock warrants but with the underlying asset being forex rather than a stock.

Although similar to currency options, currency warrants are usually longer-term contracts. Some companies may purchase currency warrants to hedge against forex fluctuations if their business is exposed to international currency markets.

Commodity Warrants

Warrants that are linked to commodities will fix a quantity of a particular commodity at a certain price on a predetermined date. For example, the warrant may specify a price of $76 per barrel of oil and set the expiry date in 18 months’ time.

This enables investors to hedge or speculate on the market’s volatility.

Benefits Of Exchange-Linked Warrants

• Losses are limited to the premium
• Wide range of underlying markets to choose from
• More long-term than options so less need for renewals
• The premium is usually lower than the cost of buying a share
• Leverage can create large profits if the price moves in the right direction

Risks Of Exchange-Linked Warrants

• Less widely available than options and CFDs
• No ownership rights or dividends before the warrant has been exercised
• The risk may be higher as exchange-linked warrants can rapidly decrease in value
• Some companies may use warrants as a way to offer lower interest rates on bonds

How To Trade Exchange-Linked Warrants

Find A Broker

We recommend traders consider the following factors when choosing an exchange-linked warrants broker:

• Fees – It is not just the cost of the warrant that traders need to account for but also the cost of brokerage fees. This includes commissions, clearing fees, regulatory fees and any deposit and withdrawal fees. Interactive Brokers (FWB Cost Plus) has exchange fees for warrants of 0.095% (EUR 15.80 maximum), as well as clearing and regulatory fees per trade.
• Trading Platform – Brokers may use external platforms or a proprietary trading package. Saxo Bank has an in-house platform with over 50 technical indicators, as well as a demo account that gives traders EUR 100,000 of virtual money. What traders need from the software will depend on their chosen strategy. However, the platform should allow comprehensive analysis of the asset that the warrant tracks.
• Markets – Exchange-linked warrants track particular markets. It is important to ensure that the broker offers a market you have a good understanding of, whether the asset in question is a stock, index, commodity or currency. Saxo Bank has an extensive collection of warrants – more than 3000.
• Regulation – This is important as the regulator that the broker holds a license with (if any) helps determine the level of scrutiny over the firm’s operations and can also determine the amount of financial support available to the trader should the broker become insolvent. Regulators like the FCA in the UK are the best option for British traders.
• Customer Support – The trading hours of exchange-linked warrants can vary depending on the exchange they trade on. We recommend choosing a broker with 24/5 support. The best exchange-linked warrants brokers will offer live chat, email and phone contact options.

Interactive Brokers – Warrants Fees

Identify A Market

The value of exchange-linked warrants is heavily dependent on the price of the underlying security. This is why traders need to have a strong grasp of the underlying market. For example, the FTSE 100 can be impacted by decisions made by the Bank of England, the fiscal policy of the UK Government, inflation data and much more.

Having a good understanding of the market will enable traders to make informed decisions – this is important in the exchange-linked warrants market, where significant risk is often attached.

Some brokers may specialise in particular types of warrants like stock warrants and not offer other products.

Buy A Warrant

Traders can purchase newly-issued warrants or buy them on the secondary market from other traders. The important thing is to do your research before buying the exchange-linked warrant and also to carefully review the nature of the product – this includes looking at its strike price and expiry date.

These checks will help you to determine whether the premium represents value for money.

Monitor The Position

The markets can change fast. Traders must keep on top of developments that may affect the price of the underlying asset and, therefore, the warrant. If investing in stock warrants, keep an eye on earnings reports. If your outlook on the underlying asset has changed, consider whether to hold on or sell it.

Exercise The Warrant (Or Sell It)

Traders may be able to sell exchange-linked warrants to other traders on the secondary market – or they may wish to wait until the warrant expires.

Remember, if it is an American warrant, you do not have to wait until the expiry date – it can be exercised before this point.

Bottom Line On Exchange-Linked Warrants

Exchange-linked warrants offer a way for traders to purchase a particular asset at an attractive price if they think its value will move in the right direction. However, they carry a level of risk that traders must be aware of – if the asset fails to reach the strike price, then the value of the warrant may significantly decline as the expiry date approaches. Exchange-linked warrants can be bought as call or put contracts and are linked to a wide range of assets, including stocks, indices and commodities.

FAQ

Article Sources

London Stock Exchange Warrants

IG Index Warrants Definition