how-warrants-work

How warrants work

It is increasingly fashionable to invest in these types of financial products. We will explain in a simple way and with an example how warrants work.

The warrants, is a financial derivative that gives the buyer the right to buy a given financial asset ( underlying asset ) to the issuer of the warrant, a deadline (due date) and at a price previously stipulated (exercise price or strike) .

Since warrants are issued by an issuer, we only have two investment options, buy calls or buy puts. Unlike options, where we have 4 investment possibilities, buy calls, sell calls, buy puts and sell puts.

Example of how a warrant works

We bought an issuer 1,000 warants for a price of 1,000 euros (one euro of premium each warrant) that give me the right to buy shares of Banco Santander at a price of 7 euros (exercise price) within a year. Let’s see the three possible situations after a year:

  1. The share has risen above 8 euros, for example to 9 euros: I exercise my right and buy 1,000 Santander shares for 7,000 euros (1,000 rights for the exercise price established when buying the warrant). If I sell at that moment the shares will give me 9,000 euros. Therefore my earnings will be 1,000 euros (9,000 euros – 7,000 euros – 1,000 euros). Therefore, the profitability of the first 1,000 euros invested in warrants is 100%, we have doubled the investment.
  2. The share is worth between 7 and 8 euros, for example 7.5: I exercise the right and buy the shares at 7 euros. I buy the shares for 7,000 euros and sell them at the same time for 7,500 euros. In total I have lost 5.00 euros (7,500-7,000-1,000). I have lost half of what I invested in warrants.
  3. The share is worth 7 euros or less: We do not exercise the right of the warrant since it is cheaper to buy the share directly on the market. If this happens, we have lost the premium, that is, we lose everything invested at the beginning, the 1,000 euros we invested in warrants.

Many investors, instead of waiting for the expiration date, sell the right again in the market and thus save themselves from having to buy the shares. For example, if it is the case that we have been right and the shares are worth 9 euros a week before the expiration date of the warrant, the price or premium of the warrant will be around two euros, so if we sell the warrant for 2 euros we will have obtained a direct profit of 1000 euros, that is, double what we invested at the beginning.