Investing in Warrants

A warrant is similar to an option, insofar that it is a derivative – in other words, its value is "derived" from an underlying financial instrument, security, or asset – and gives its holder the right to buy or sell that security at a fixed price, on, or before, a specified date in the future.

The range of securities traded as warrants has increased over the years, and may, nowadays, include shares, share price indices, currencies, commodities, etc.. Unlike options, however, warrants are issued by companies, banks and governments, rather than stock exchanges, but are, nevertheless, traded in many key financial markets across the world.

How Warrants Work

Warrants are usually of one or two types, investment, or trading. The simplest type of warrant grants the right to buy, or sell, an individual stock, or index, but warrants on commodities, such as crude oil, and currencies, allowing investors to take a position on exchange rates, for example, are other possibilities. Sometimes more than one type of warrant can be used to achieve the same investment objective.

Index warrants are often the most actively traded type of warrant on overseas markets, not least because the primary market indices – FTSE 100, Dow Jones, Nikkei 225, etc. – are closely monitored, allowing investors to make informed judgements.

The most important feature of any warrant, however, is the high level of leverage and gearing involved. Warrant prices are low in comparison to the price of underlying securities – shares, etc. – but any movement in the price of an underlying security, favourable or unfavourable, will be magnified, in percentage terms, in the price of a warrant. This means that larger capital gains, and losses, are possible.This can obviously be to the advantage of an investor in a "bull" market, in which prices are rising, but also affords some protection in a "bear" market, where prices are in decline; the price of a warrant is already low, in relation to the price of a share, itself, so any losses incurred will also be lower.

On the downside, if the price of a share, or shares, for example, remains below the fixed price – known as the "exercise" price – at which you can "exercise" your right to purchase, beyond the expiry date of the warrant, the warrant loses any redemption value and becomes worthless. Furthermore, unlike a shareholder, a warrant holder has no voting, or dividend rights, and no control over the company issuing the warrant, even though he, or she, may be directly affected by the actions of that company.

In the United Kingdom, the listing of warrants, and the conduct of businesses selling warrants to private customers, is governed by rules introduced by the FSA ("Financial Services Authority") in 2002. These, for example, place certain restrictions on the type of underlying securities that can be traded as warrants, and assign certain obligations to authorised firms involved in the process.

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