Why Investors Use Warrants

As with other investment vehicles, warrants have their own distinct advantages and disadvantages.

Some advantages:

Warrants can provide leverage. This means a warrant buyer can pay a relatively small premium for market exposure in relation to the contract value. To buy a warrant, investors only have to pay the premium—that is, the price of the warrant-- which is a small percentage of the price of the underlying asset itself. As a result, the potential profit on warrants can be far greater in percentage terms than the potential profit on the underlying asset. This difference is known as the warrant's leverage. Leverage indicates the extent to which a warrant enhances returns on the underlying asset. It is calculated by dividing the underlying's price by the warrant's premium (after being adjusted for parity).

  • Maximum loss is already known. The maximum loss that can be incurred on a warrant is never more than the amount originally invested. In a worst case scenario, the holder of a warrant can lose the entire premium (100% of the investment), which is still only a small amount compared to the losses that could have been made on the underlying asset.
  • Cost-effective way to invest in worldwide assets. Warrants allow you to invest in the world's largest multinationals, leading indices, currencies, thematic baskets and even oil at a minimal cost. It is much more difficult and expensive to obtain direct access to these investments than it is to submit a simple order to buy a warrant based on them. You can buy warrants on these assets on NYSE Euronext via your broker. Warrants based on Japanese or US shares are traded in euros, although such warrants do come with currency risks. 
  • Time element. Since a warrant's expiration date may be several years away, warrants allow you to wait for the optimum moment to buy or sell the underlying asset. You can benefit from rises in share prices now, instead of having to wait until you have the necessary capital at your disposal. You can also wait to see how a share performs before buying it. If the underlying share does not perform as hoped, your loss is limited to the premium you paid for the warrant. If the performance of a particular share is disappointing you can delay selling. And lastly, you can use put warrants to protect against the risk of a sharp drop in the price of your shares if you plan to sell them in the future to finance an expensive purchase.

Some disadvantages:

  • Time always works against the warrant holder. If the underlying security does not perform in the way you predict before the expiration date, your warrant will be worthless. This risk affects the warrant's premium. As the expiration date approaches, it becomes less likely that the underlying security's value will fluctuate sharply before it expires, which reduces the warrant's value. Moreover, if the underlying security stays at the same price for a long period of time, the warrant's premium will gradually decline. As soon as a holder recognizes that their market prediction is wrong, he or she should cut their warrant position and buy another one more adaptable for the current market conditions. 
  • Leverage can work against investors. With warrants, price movements in all directions are magnified, so a small adverse movement in the underlying security can have a major impact on the value of the products. Leverage explains why warrant premiums frequently rise or fall by more than 50% in a day.
  • Volatility can also work against investors. Volatility is the tendency of the underlying security's market price to fluctuate either up or down. It reflects the magnitude of a price change, but it does not imply a bias towards price movement in one direction or the other. Thus, volatility is a major factor in determining a warrant's premium. The higher the volatility of the underlying, the higher the premium, because there is a greater possibility that the warrant will become profitable. Generally, as the price of an underlying increases, the volatility decreases. As a result, the effect on the premiums of calls warrants are uncertain: what is earned on the underlying price can be lost on volatility. That is the main reason why the premium of a warrant does not always increase when the underlying price increases. 

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