Useful Warrants terms

There are a number of different terms that are often used when investing in warrants and it's important to understand what these mean if you're going to trade this important market instrument successfully.

Please click on each of the tiles below for more details

• Delta

  Delta shows the approximate change in the warrant price for a small change in the underlying share (or asset) price.

  Delta =

  Change in warrant price

  Change in underlying share price

  Therefore, a delta of 50% means that the warrant should move approximately $0.005 for each $0.01 move in the underlying asset. Deltas for puts are negative since they move inversely with the underlying price.

  General rule of thumb for delta
  	Call	Put
  In-the-money(max)	100%	-100%
  At-the-money	50%	-50%
  Out-of-the-money(min)	0%	0%

  Deltas range from 0 to 100% for calls and 0 to -100% for puts

  Helpful tips on how to use Delta

  • Delta can also be viewed as an indicator of the probability that a warrant will expire in the money (ie. with value). For example a warrant with a delta of 20% has a 20% probability that it will expire with value, and 80% chance that it will expire worthless.

  • When using delta to estimate how much a warrant price will move for a particular price change in the underlying, you must take into consideration the warrants per share number to estimate the “delta per warrant”. See an example of how you can use delta and warrants per share to calculate a warrant’s sensitivity.

  • Use caution when choosing warrants that have deltas either above 80% (termed deep in the money, ITM) or below 20% (termed deep out of the money, OTM) as issuers will often widen the offer spread for these warrants to discourage further buying in these warrants. Deep OTM warrants in particular, are risky for investors to buy.

  • Macquarie provides delta for all warrants listed on the Hong Kong Exchange, you view these via theWarrant Search Tool or the Warrant Terms page

• Conversion Ratio

  Conversion Ratio (also known as warrants per share) shows the number of warrants needed to exchange for one underlying share/index futures at expiry.

  The purpose of conversion ratio is really just to break down the warrant into smaller parts, so that a warrant with a price of say $1.00 can be broken down into smaller parts each worth $0.10 by using a conversion ratio of 10. When calculating many indicators or ratios, such as delta, premium, etc you often need to take into account the conversion ratio.

  Warrants	Price	Strike	Conversion Ratio	Delta	Delta per warrant	Sensitivity* ($0.10 share move)	% Change in warrant
  A	0.40	5.00	1:1	50%	50%	0.05	12.5%
  B	0.04	5.00	10:1	50%	5%	0.005	12.5%
  C	0.004	5.00	100:1	50%	0.5%	0.0005	12.5%

  *Sensitivity change based on 10 ticks.

  Let's take a look at an example to understand the effects of different conversion ratio. In the above table, all three warrants in the table above have the same strike, expiry date etc. with conversion ratio the only difference between them.
  
  Notice that Warrant A has a conversion ratio of 1 and therefore requires 1 warrant to exchange for one underlying share at expiry. It has a price of $0.40.
  
  Warrant C on the other hand has a conversion ratio of 100 and requires 100 warrants to exercise at expiry, 100 times more than Warrant A. Therefore it costs exactly 100 times less at $0.004.
  
  The delta per warrant for Warrant A, Warrant B and Warrant C will also be different as they have different conversion ratio figures. Remember that all three warrants are exactly the same, with the same strike and expiry. The delta for all three is therefore the same. However, the delta per warrant for Warrant A is higher as a result of being divided by a smaller conversion ratio of 1 compared to Warrant B for which the delta will be divided by 10. Warrant C will have the lowest delta per warrant of 0.5%.
  
  The important point to understand is that while warrants with the lower conversion ratio will have a higher delta per warrant, they are also more expensive and therefore move the same in percentage terms. Meaning, if you purchased any of the above warrants, the return you will receive in percentage terms will be exactly the same. In this example, each of the warrants will move approximately 12.5% for a $0.10 move in the underlying share.
  
  So while the conversion ratio is important for calculating ratios such as delta, sensitivity, breakeven price at expiry etc., it should be a major factor in the decision making process for most warrant investors who are choosing a warrant.
  
  

• Warrant Sensitivity

  A warrant’s “Sensitivity” is an estimate of how much the underlying price needs to move for a corresponding one tick (or minimum spread) movement in the warrant. We use delta and conversion ratio to calculate the sensitivity of the warrant to the underlying.

  Example:

  Type:

  Call Warrant

  Warrant Price:

  $0.20

  Underlying:

  Share A

  Conversion Ratio:

  10:1

  Expiry:

  1 December

  Delta:

  100%

  Delta per warrant	= 100% / 10
  	= 10%

  In this example, we are using a call warrant over Share A, the warrant has a price of $0.20.

  The conversion ratio is 10 and the warrant expires on 1 December. The delta is 100%, which means it has a 100% chance of being in- the-money (ITM) when it expires.

  Calculating the warrant sensitivity

  To calculate how many ticks in the underlying is required for a one tick move in the warrant (i.e. minimum tick of $0.001 for warrants priced below $0.25), you first need to know the delta per warrant.

  You would recall from the previous chapter on “Delta” that the delta formula is as below:

  Delta Formula

  Delta =

  Change in Warrant price

  Change in Underlying Warrant price

  To calculate the “Delta per warrant”, you divide 100% by the conversion ratio of 10, to get a figure of 10% or 0.10. Now that you have the delta per warrant, you can calculate the Sensitivity, i.e. how much the underlying will move for a 1 tick move ($0.001) in the warrant.

  Sensitivity Formula

  Change in Underlying =

  Change in Warrant price

  Delta per warrant

  Simply divide the change in warrant price of $0.001 by the delta per warrant of 10%, and you would arrive at a sensitivity of $0.01. Meaning that each time the share price moves $0.01, the warrant price will move one tick, or $0.001.

  See illustration for the calculation below.

  Change in Underlying =

  0.001

  10%

  = $0.01

  With a sensitivity of $0.01, which is 1 tick in Share A (as with all Hong Kong stocks above $1.00), we say that this warrant moves “tick for tick”, which means its price will move one tick for every tick in the underlying share.

  For index warrants, the same calculation can be used.

  Example:

  Type:

  Call Warrant

  Warrant Price:

  $0.20

  Underlying:

  HSI

  Conversion Ratio:

  6000:1

  Expiry:

  1 December

  Delta:

  60%

  Delta per warrant	= 60% / 6000
  	= 0.1%

  In the case of the above Hang Seng Index (HSI), the delta per warrant can be calculated by dividing the delta of 60% by the conversion ratio of 6000, which gives 0.1% or 0.001. Hence, for the warrant to move 1 tick ($0.005), the HSI will therefore move, $0.005 divided by 0.1%, which is 5 points.

  See illustration for the calculation below.

  Change in Underlying =

  0.005

  0.1%

  = 5 points

  Helpful Tips on how to use Warrant Sensitivity

  • Always remember to take into account the conversion ratio when looking at sensitivity.

  • Warrant sensitivity is primarily used by short term day traders and investors interested in the small/short term movements in a warrant. For all other investors, Delta or Effective Gearing are likely to be more useful.

  • You can view the warrant sensitivity for each warrant via the Warrants Terms Page.

• Breakeven Price

  Calculation of the breakeven price is useful only if you were planning to hold the warrant till expiry, otherwise, breakeven is simply the price you bought the warrant at.
  
  There are actually two ways to think about the breakeven price. If you’re not planning to hold the warrant until it expires, the breakeven price will be the price you paid for the warrant initially. If you are holding on to the warrant until it expires, the breakeven price is the price of the underlying share at expiry such that the warrant is at the same price you had purchased it for initially.
  
  To understand how the breakeven price at expiry is calculated, let’s look at an example.

  Example:

  Type:

  Call Warrant

  Warrant Price:

  $0.15

  Strike:

  $25

  Underlying Price:

  $23

  Conversion Ratio:

  10

  Cost of buying the share via call warrant

  = (Call warrant price x Conversion ratio) + Strike

  = ($0.15 X 10) + $25

  = $26.5

  Let’s assume you are planning to hold this call warrant until its expiry date. The strike of the call warrant is $25, the conversion ratio is 10. When you first purchased the call warrant, it was $ 0.15 while the underlying share price was trading at $23. The breakeven cost on expiry will be $26.5.

  Helpful Tips on how to use breakeven

  • Another simple way to calculate breakeven is to look at premium (or time value). Premium represents the amount that the underlying share has to increase by in order for the warrants to be at breakeven at expiry. This will be explained in further detail in the next section.

  • Remember that the breakeven price is the price that the share needs to reach AT EXPIRY for the warrant to equal the same price that you paid to purchase the warrant. The breakeven price for time periods before expiry will be lower.

  • Warrant sensitivity is important for short term day traders and investors interested in the small/short term movements in a warrant. For all other investors, delta is likely to be more useful.

  • You can view the breakeven for all warrants via the Warrant Terms page.

• Premium

  Now to calculate the price that the underlying shares needs to reach at expiry to break even, you need to multiply the warrant price by its conversion ratio and then add the strike. So that’s $0.15 multiplied by 10, plus $25. This gives you $26.5.
  
  $26.5 is your effective cost of purchasing the share using the warrant. That is, the price the stock has to reach at expiry to breakeven on your initial purchase price of $0.15 per warrant. This is what we term as the breakeven price at expiry.

  Example:

  Type:

  Call Warrant

  Warrant Price:

  $0.15

  Strike:

  $25

  Underlying Price:

  $23

  Conversion Ratio:

  10

  Cost of buying the share via Call Warrant

  (Warrant Price X Conversion Ratio) + Strike

  = ($0.15 x 10) + $25

  = $26.5

  
  

  Cost of buying the share directly

  Share Price

  = $23

  
  

  Difference

  = $26.5 - $23

  = $3.5 Premium (15.21% of Share Price)

  You will notice that there is a $3.5 difference between this $26.5 figure and the direct cost of buying the share at $23.
  
  This difference is what we term as premium. While $3.5 may seem high at first sight, it is only 15.21% of the underlying share price. A relatively small price you have to pay in return for the gearing you enjoy from gaining exposure to the underlying at a fraction of its cost. Generally, premiums are higher for longer-dated warrants. They are also higher for warrants with higher effective gearing levels.

  Helpful tips on how to use Premium

  • Having a higher premium level does not mean that one warrant is necessarily more ‘expensive’ than another. Premium will be higher for warrants that are longer dated and also for warrants with higher gearing levels.

  • Premium is not the best indicator to use to compare the relative price of one warrant over another. When comparing similar warrants, to determine which is cheaper, you should use implied volatility.

  • • Premium is most useful for estimating the amount of time decay that a warrant will experience over its life. Say for example, a warrant has a premium amount of $0.2 and it has 2 months left to expiry. You can then assume that (assuming all other factors are constant) the warrant will decay in approx. $0.1 per month over the next 2 months. This however will not happen in a straight line and will speed up as it approaches expiry, click here to read more about time decay.

  • You can view the premium for all warrants via the Warrant Terms page.

• Gearing

  Gearing indicates the increased number of warrants you can buy with a certain amount of capital as opposed to buying the underlying share i.e. a gearing level of 10x means that you will be able to buy 10 times as many units of underlying exposure than you could if you purchased the underlying share.
  
  

  Gearing = Underlying Price / (Warrant Price x Conversion Ratio)

  Helpful Tips on how to use Gearing

  • Gearing alone is not a very useful ratio as it does not take into account the responsiveness (delta) of the warrant. Gearing is often quoted as a standard ratio, but on its own is quite an impractical measure.

  • Effective gearing that takes into account the delta is a better reference point for investor.

• Effective Gearing

  A similar indicator to ‘delta’, it combines gearing and delta to express the warrant price movement as a percentage.

  Effective Gearing = Gearing x Delta

  There are two main uses for effective gearing:

  1. 1. Indicate the % change in the price of a warrant relative to a 1% change in the underlying

     Take for example a warrant with an effective gearing of 10x. This means, the warrant should move approximately 10% for a 1% movement in the underlying share.

     Stock 1% x 10 = Warrant 10%

     A higher effective gearing generally translates to a higher profit potential and also a higher level of risk.

  2. 2. Helps you decide how much to invest

     With effective gearing, you can estimate the effective share exposure in the underlying asset that a warrant holder gains by holding the warrant.
     
     Take for example a warrant with an effective gearing of 10x. This means if an investor buys $10,000 worth of the warrant they will have an effective share exposure of $100,000.

     $10,000 Warrant investment x 10 = $100,000 effective stock exposure

     Similarly, if you are currently holding $200,000 worth of shares and wish to release some of these share capital without losing the stock exposure, you can do so by purchasing $20,000 worth of a warrant with an effective gearing of 10x.

     $200,000 effective stock exposure / 10 = $20,000 Warrant investment

  Helpful Tips on how to use Effective Gearing

  • You can view the effective gearing for all warrants via the Warrant Terms page.

• Implied Volatility

  Implied volatility is a key factor affecting a warrant’s pricing. It is the level of volatility that is implied by the current market price of the warrant, and represented as a percentage.
  
  Implied volatility can be used to compare the relative price of similar warrants. The higher the level, the more expensive the warrant (all other pricing factors held constant).
  
  Implied volatility is influenced by:

  • ・Demand and supply forces
  • ・The level of volatility in market prices generally
  • ・Exchange traded options (ETO) and over the counter (OTC) markets

  

  Supposed you observe the price movement of Call Warrant A on the market to be as such:

  Time	Share Price	Call Warrant A Price	Implied Volatility
  9:31am	5.00	0.100	70%
  10:00am	5.01	0.105	70%
  11:00am	5.02	0.110	70%

  Call Warrant A is moving tick-for-tick with the underlying share price, moving up one ‘tick’ ($0.005) for every one tick $0.01) in the underlying share with the implied volatility remaining constant.
  
  Later in the day, the price movements are as follows:

  Time	Share Price	Call Warrant A Price	Implied Volatility
  2:30pm	5.12	0.160	70%
  2:32pm	5.12	0.165	71%
  2:35pm	5.13	0.170	70%
  2:45pm	5.14	0.175	70%

  As highlighted in red, price of Call Warrant A moved up one tick from $0.16 to $0.165 despite the underlying share price remaining unchanged at $5.12. The increase in warrant price is attributed to the increase in implied volatility from 70% to 71%.
  
  What may have caused the implied volatility to increase?

  • ・Increase in demand for the warrant, or
  • ・Market related event causing uncertainty in the market, hence, a higher forecast level of volatility in the market, or
  • ・An increase in the implied volatility level of a similar option in the ETO or OTC market.

  Before the market closes, the trading pattern of the underlying share and the call warrant are as follows:

  Time	Share Price	Call Warrant A Price	Implied Volatility
  3:00pm	5.15	0.185	71%
  3:15pm	5.16	0.190	71%
  3:30pm	5.16	0.185	70%
  3:45pm	5.17	0.190	70%

  Call Warrant A continued to trade tick-for-tick with the underlying share up until 3:30pm when the call warrant declined from $0.19 to $0.185 even though the share price stayed put at $5.16.
  
  What may have caused the implied volatility to decrease?

  • ・Decrease in demand for the warrant, or
  • ・Increase in market confidence, hence, a lower forecast level of volatility in the market, or
  • ・Decrease in the implied volatility level of a similar option in the ETO or OTC market.