How To Use Call Warrant When Investing in Stock

First of all, what is call warrant? It gives owner (buyer of warrant) the right to buy the issuer’s share at a certain price (which we call it exercise price). Call warrant is usually issued by the listed company itself. Why do we buy warrant when we can buy the stock right away? Call warrant enable the owner to buy the underlying share at a discounted price when/if the stock price is higher than the exercise price. Besides, short term traders buy warrants because of high leverage it gives with considerable low investment capital.

Note: I will start referring call warrant as warrant in subsequent text.

Have you ever thought the stock you’re planning to invest is way too expensive that you can’t afford to purchase enough? How good is it if the stock price will come down during the right time when you have the money? Consider the odd timing of stock market and you being a busy person yourself, such chance are quite rare. But you don’t need to wait. With warrant at hand, you are owning the right to buy the share at a fixed lower price. However, even though the exercise price is much lower than the stock price during exercise, that does not mean you can profit from it, simply because the warrant price is not zero as well. In order to buy certain amount of underlying shares in exercise price, you also need to own up to certain amount of warrant units depending on the conversion rate. To understand more about warrant, i will illustrate through a few examples.

We will use Supermax warrant SUPERMAX-CW as our example, following are some fact:

Warrant Type: European Style
Exercise Ratio/Conversion rate : 8 SUPERMAX CW : 1 SUPERMAX Share
Exercise Price : RM 5.60
Issue Price : RM 0.175
Listing Date : 9 March 2010
Expiry Date : 10 March 2011

Warrant Type – There are mainly two types of warrants available in the market; American style and European style. With American style, you can exercise your right at any time up to the expiry date. While you could only exercise your right on expiry date for European style warrant.

Exercise Ratio – 8:1 means for every 8 units of warrant you own for SUPERMAX-CW, you have the right to buy 1 SUPERMAX share at RM5.60 each on expiry date.

Exercise Price: At the time of writing on this article, SUPERMAX is floating around RM7.0 – 7.1. So assuming that the share price never go lower than RM5.6 till 10 March 2011, you can exercise the right to buy SUPERMAX share at RM5.60 per unit. Of course, you still can buy the share if the share price go lower than RM5.60, but that doesn’t make sense right?

Issue Price – This is the warrant unit price. This price will usually go up in tandem with the underlying share, vice versa. In the event that the underlying share price goes lower than the exercise price, warrant will become no longer attractive thus the warrant price will be much beaten as well.

Listing Date – the date the warrant is issued and listed in stock exchange.

Expiry Date – Any warrant not exercise beyond this date is worthless and can’t be exercised anymore. Thus warrant also depreciate when the expiry date is approaching, unless the underlying share increases in value which could possibly off set the depreciation because of demand.

So how do we make sense out of this?

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First of all, let’s set a target quantity you would like to purchase on exercise date (expiry date). Say 2000 units at price RM5.60.

Price you pay for buying 2000 unit of SUPERMAX share at exercise price : RM 5.60 x 2000 = RM11,200

In order to buy 2000 units of SUPERMAX share, you need to have 16,000 units of SUPERMX-CW, because 8:1 = 16,000: 2,000.
Cost to buy 16,000 unit of SUPERMX-CW : RM 0.175 x 16,000 = RM2,800

So the total cost of Supermax stock investment plus owning the warrant is RM11,200 + RM2,800 = RM 14,000

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Now here is the fun part, how do you know if you are buying it cheap? A bare eye will probably think exercise price of RM5.60 and market price of RM7.00 is cheap.

Scenario (A) – Assuming on date of exercise, the underlying share price is still RM7.00, this is the outcome:

RM7.00 x 2000 = RM 14,000

If you sell the stock right away at RM7.00 per share, you are even (market price: 14,000 – cost price: 14,000 ). Minus out brokerage fees, you are in losing ground. You see, even at the discounted price of RM5.60, you are only even after including the warrant purchase cost or RM2,800.

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Scenario (B) – However, if the share price is RM10.00 on exercise date then it would be a different story.

RM10.00 x 2000 = RM 20,000

If you sell the stock right away at RM10.00 per share, you will be earning a cool RM6,000 (Market price: 20,000 – cost price: 14,000).

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Scenario (C) – Now, let revisit scenario (A) and see if we can turn the situation around by tweaking the quantity. I will increase the warrant quantity up to 32,000 units, so we have the right to buy 4,000 underlying SUPERMX share.

The cost of investment up till exercise date : RM5.60 x 4,000 + 32,000 x 0.175 = RM 28,000

While the market price up till exercise date, RM7.00 : RM7.00 x 4,000 = RM 28,000

If you sell the 4,000 unit of share right away at RM7.00, you still don’t earn anything even though you increase the warrant quantity.

You see, by increasing the number of share you buy on warrant exercise, you still can’t turn a profit given the warrant price and underlying share price remain fixed. In contrast, as the warrant unit price increases so does the cost of investment, therefore the break-even point gets higher as well. Of course, the main thing to bet on when using warrant as tool in investing is the underlying stock price movement, the higher the stock price goes, if you have acquired the warrant in low price (usually during early life span of the warrant), the break even point would be low as well. At the writing of this article, SUPERMX-CW has appreciated to RM0.30 because of appreciating underlying share, thus if investor starts subscribing the warrant now will require a much higher underlying stock price to break even. As a conclusion, before investing using warrant, be warned. Take note of the exercise date. Do have a strategy. Make detailed calculation of all the figures before jumping in. Warrant can be so sweet in bare eyes as it offers the stock at large discounted price but it could also cause loss at a blink of an eyes.

Readers take note: I wasn’t recommending SUPERMAX share in KLCI, it was just an example to illustrate use of warrant.