Know your limits

The market in warrants is growing and high net worth investors are benefiting from their accessibility and simplicity.

During the past 16 years, covered warrants have become a key way for investors in general to fine-tune their portfolios and for high net worth investors in particular to experience the advantages of the derivatives markets. The success behind this product lies in three main factors: risk/return profile, accessibility and simplicity. As far as the risk/return profile is concerned, investors know that the leverage potential of the instrument means that, on a specific amount invested, more returns can be achieved relative to a direct investment in the stock. However, leverage can work both ways and therefore an investment in warrants has a high-risk profile. Nevertheless, what really appeals to high net worth investors is the fact that their loss is always known up-front, thus limited, while the upside is potentially unlimited. The accessibility of covered warrants lies in the fact that an investor can buy a warrant just as easily as a simple stock, through their regular broker and account with the same costs and access to the same level of market information. And the simplicity lies in warrants being plain vanilla options and therefore the final payout is transparent: either the full upside of the underlying instrument is retained or the up-front premium is lost. The past five years provided perfect ground for warrants to grow exponentially and to become one of the fastest growing markets in Europe, in terms of volumes, number of issues and issuers. The total number of issuers had increased to 109 by 2001, with the top 20 issuers representing 89.8 per cent of the total number of issues (International Warrants Institute, Issue No 2, May 2001). The market rally of the late 1990s and the growing influence of online brokers in recent years – plus rising cross border investment flows – fuelled interest in this product, particularly from high net worth investors. In Europe, the past decade’s popular affair with the stock market saw many thousands of investors holding stock directly instead of indirectly via mutual funds. Increased financial expertise, together with the growth in accessible financial market information, led to an increasing number of private investors making their own investment decisions on single stocks and markets – this was evidenced by the increased use of online brokerage. For the experienced stock buyer, warrants were just one step further. Warrants on single stocks account for approximately 77 per cent of all warrants issued, followed by warrants on equity indices (14 per cent) and currency warrants (5 per cent) (source: IWI). The predominance of warrants on single stocks can be partly explained by the fact that price changes in the underlying can be accessed and monitored more easily than for example in stock baskets or even equity indices. According to IWI statistics, in terms of nationality of the underlying, German and US underlyings dominate, except for the notable exception of Nokia, which is the second most popular underlying worldwide. The warrant market in 2001 was characterised by an increase in the issuance of warrants. Issuers, needing to adapt their product ranges to the falling levels of the underlying, had to continuously issue in order to offer product profiles which met investor appetite. Despite this, the turnover figures registered on the secondary market during 2001 showed a notable decrease in traded volume. As the bulk of warrant turnover in most markets is private and retail driven, private and retail investors have tended to shy away from positions in warrants just as in the equity markets generally. However, there has been an increasing usage of put warrants that benefit from a drop in the price of the underlying asset, and thus are ideally suited to benefit from bear markets. During the past 18 months, there has been a slight change in investors’ use of warrants. Being such a high leveraged product with tremendous liquidity, the warrants market has seen an increase in short-term traders who move quickly between positions. An increased market sentiment of a capped upside potential, together with greater uncertainty in the equity markets, has led to investors dropping their long positions after each rally. High net worth investors have taken advantage of the lateral market conditions, buying call warrants when the market hits the lower range and changing to put warrants when the market rallies through the upper range. The recent behaviour of the markets has also led to the growing appearance of alternative products, such as certificates and other types of warrants. Benefits The strength of warrants lies in their simplicity. Defined in the simplest way, warrants are options that are negotiated in the form of securities. Among several types of options, like over-the-counter contracts or exchange traded options, warrants are distinguished by the fact that they bear the form of listed securities, like bonds or certificates, thus providing numerous benefits. The first is that any investor can easily buy or sell warrants on a stock exchange, where the issuer acts as a market-maker, providing liquidity to their own product. Another benefit is the leverage of the return. Warrants amplify the movements of their underlying instrument thus providing substantial returns for a low economic outlay. Other features give the product a distinct edge over other instruments. One of the driving forces behind the development of the warrants market in Europe has been the ease of access to information from issuers such as Citibank. Real-time warrant prices are available at no cost and placing an order in the market is as simple as indicating a security code of the warrant required. Cost is also a factor: brokerage fees are low compared with other option products, commissions being in line with any equity transaction. And warrants can be bought and sold in small amounts more efficiently than can the underlying equity, so that the investor can take positions in warrants with little amounts of money. Warrants also offer the investor the opportunity to benefit from upward movements on the price of the underlying instrument – call warrants – as well as from an expectation of price decline for a certain underlying through investing in put warrants. Strategies The most common warrants strategy is the speculative investment, which takes advantage of the leverage factor inherent in a warrants investment. Investors can achieve the same exposure to the underlying stock by investing smaller amounts in warrants as through buying the stock outright. For instance, an investor can assume the same risk as buying a stock with a price of e100 through investing in a call warrant worth e10. When the stock price moves from e100 to e101, this represents a 1 per cent rise. If the warrant purchased on the same stock at e10 moves to e11, the investor makes 10 per cent, having invested a smaller amount but gaining the same exposure. Call or put warrants allow investors to diversify and internationalise their portfolios easily and cheaply. Through a local stock exchange, it is possible for an investor to take positions on both local and foreign underlyings. Citibank has warrants on more than 350 underlyings worldwide. Other ways in which options and warrants can be used to steer investor’s risk/return exposure through the highs and lows of the financial markets include winning on bear markets with put warrants. These warrants allow the investor to benefit from falling prices in the market. By holding a short position at a given price (strike) the holder will see the warrant value moving up as the underlying is moving down. Using the previous example, when buying a put at e10, a downward move in the stock from E100 to E99 will make the put warrant move up to E11. Put warrants can also be used as a hedge tool. Investors who hold a long position on a stock can use put warrants on that stock to protect/ insure the potential downside movement of its price, as revenues on the former compensate the loss on the latter. If the stock price rises, after a certain level the put warrant will become worthless and the investor will continue to make profits on the long stock position. Warrants also provide the possibility of extracting cash out of one portfolio while maintaining the same level of exposure to market movements. As an example, an investor could consider selling stock at e100 and reinvesting e10 in a call warrant. If the stock price goes up to e101, the gain on the warrant will be the same, that is, E1. If the stock goes down to e99, the warrant will also lose E1. The main advantage is that the investor is only committing E10, leaving E90 free for other investments. Investors can also construct their own capital guaranteed investment while benefiting from an upside in the market. An investor with e100 in capital could consider buying a warrant at e10 and deposit the other e90 in a one-year risk-free deposit that pays 11.11 per cent. After one year the investor will receive e100 from the deposit, while participating in 100 per cent of the upside of the call warrant. These are straightforward examples and other factors do affect the pricing of warrants, such as movements in implied volatility. Trading The role of the exchanges is crucial, as in many countries they represent the forum through which all investors can access the products. Citibank was the first issuer to quote its prices on an automated continuous basis across an exchange (the French exchange in May 1993), which was rapidly rolled out to other stock exchanges equipped with screen-based trading systems. This initiative was driven by Citibank’s desire to create additional liquidity for investors, in addition to its bid/offer spreads as market-maker. Replicated by other warrant issuers, this has now become a market standard. This is a positive development for investors, which has contributed to the growth of the markets in these countries. In the development of off-exchange trading and new technologies, warrants are showing their inherent flexibility. In Germany, around 50 per cent of warrants are now traded off-exchange. Citibank was the first to establish a real-time electronic transaction platform, the Citibank Automated Trading System for Warrants (CATS-OS) system, giving investors instantaneous trading prices directly from the issuer. As the Internet becomes an increasingly important distribution channel, the number of intermediaries and investors linked to an electronic transaction platform is growing. With fast moving prices and deep liquidity, warrants are an ideal product for online trading. A big portion of the European daily turnover in warrants flows through Internet screens these days. In some countries, like Spain and France, online brokers account for about two thirds of the market.

Certificates As an alternative to warrants, Citibank began to issue tracker certificates in the early 1990s. These products replicate the underlying instrument, normally a stock index, but can be bought in smaller quantities and with the same level of liquidity and access found in warrants. Trackers are frequently used as an alternative to buying the full basket underlying a stock index like the Dow Jones Industrial or the Nasdaq 100. Until the appearance of such certificates, the only alternative that high net worth investors had to holding a straight position in an index was via futures. However, trackers have proved easier to trade, cheaper in terms of fees and more suitable for non-institutional investors. In 1999, Citibank understood the need for high net worth investors to hold less risky positions in equity and launched the first STAR certificates on individual stocks. Like tracker certificates, these products also replicate the underlying but trade at a discount in exchange for a limitation on the potential upside. They have the same level of liquidity and accessibility as warrants but the difference is that the investor benefits from a stable or slightly bullish view (lower volatility) in the price of the underlying instrument. Except in the case of an underlying stock increasing dramatically in value, it is always preferable to hold a STAR on that stock. Other types of certificates built on equity-linked structures have appeared during the past 18 months and this market is expected to grow to be truly complementary to the warrants market in the near future.

Main concepts For any investor who wants to take positions in the market using warrants, the following are some basic concepts that need to be understood before acquiring the product.

• Types of warrants: call warrants benefit from an upward price movement of the underlying whereas put warrants benefit from a downward trend.
• Exercise or strike price is the price at which the holder of a warrant has the right to buy (call warrants) or sell (put warrants) the underlying asset.
• The underlying assets are financial instruments, like stocks, equity indices, currencies, stock baskets and commodities. Today, the biggest issuer worldwide, Citibank, has more than 7000 warrant issues outstanding on approximately 350 underlyings.
• The expiry date is the day until which the holder of the warrant has the right to buy or sell the underlying at a predefined price (strike price).
• The risk profile of a warrant (at expiry date) is a limited downside risk with a theoretically unlimited upside. The risks that a warrant holder faces are identical to those associated with a long position in an option. Time decay and a decrease in the level of implied volatility hurts the price of the warrants but, on the other hand, increasing volatility and a correctly anticipated directional movement in the underlying will result in a higher returns when measured against the investment in the underlying asset.
• Investors should select the underlying and the warrants that are best adapted to their expectations, both with regard to the extent of the expected price movement as well as the period over which this movement will occur. It is essential to select an issuer with a recognised secondary market- making record of providing liquid and stable bid/offer spreads over the lifetime of the warrants. After this analysis, investors should contact any registered approved participant of the stock exchange to acquire the warrants.