Warrant versus option trading
August 10th, 2008Business Times - 11 Aug 2008
WARRANT INSIGHTS
Warrant versus option trading
LAST week’s column looked at the main differences between structured and company-issued warrants. This week, we’ll try to answer one of the most common questions about warrants: How does warrant trading differ from options trading?
In theory, both types of instruments behave the same - call options give holders the right to buy the underlying stock from the option writer and so gain in value when the stock rises, while put options give holders the right to sell the underlying stock to the option writer and so gain in value when the stock falls.
Other similarities are that both have fixed exercise prices, fixed expiry dates (usually short-dated) and are priced using models based on time and volatility. There are, however, significant differences that investors should be aware of.
In options markets, it is the exchange that decides which options can list. For warrants, it is issuers that decide, based on feedback from clients, market demand and ease of hedging.
Any investor with a valid options trading account can write, sell or even short-sell options, whereas in the warrant market, only issuers are authorised to sell warrants and short-selling is actively discouraged. In Hong Kong, for example, short-selling warrants can lead to a jail sentence.
This means options offer greater flexibility. If, for example, an investor spots what he believes to be an over-priced option, he can try to capitalise by short-selling it before covering his position later if the price falls.
This is not the case with warrants. Prices are almost always set by the issuer, playing the role of the market-maker, and are thus assumed to be fair. Also, trading is aimed solely at enabling investors to profit from their view of the underlying stock’s direction - and not from any perceived mis-pricing.
However, investors should note that short-selling exposes an option seller to potentially unlimited risk. Selling a call, for example, can lead to a huge loss if the underlying market suddenly rises sharply and the seller was not properly hedged. So although warrant trading is less flexible, it is also less risky. Investors need only focus on forming a view on where the underlying market may head - and buy accordingly.
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