The best guide to derivative warrants: types and examples

Summary:

Whether you’re a newcomer eager to learn more or well-versed in the realm of finance, there comes a time when you want to build your investment portfolio. In this guide, we’re going to explore the concept of derivative warrants. To make the subject easy for you, we use simple explanations and easy examples. 

When you’re done, the fundamentals will be crystal clear. In no time, will you be able to leverage theoretical knowledge into practice and make informed decisions about derivative warrants based on your financial objectives and the market’s outlook.

Introduction 

The world of finance is ridden with complex terminology and the term derivative warrants feels no different. However, don't let this intimidate you. It’s not as complicated as it sounds. We’re going to break down the term in a simple way, so you understand while giving you all the financial expertise you need.   

Whether you’re an eager learner dipping your hands into the stock market or a seasoned investor looking to broaden your portfolio, you’re in the right place. 

By the end of the blog, you’ll have a solid grasp of what they are, the various types, and even real-world examples to drive the point home.   

Without further ado, let’s jump right into derivative warrants.  

What is a derivative warrant? 

Derivative warrants are financial instruments that allow the investor to buy or sell an asset at a specific price before it expires. Typically, investors can use this tool to safeguard themselves against possible losses or speculate on the movement of price. Meaning, it helps decide whether or not the warrant is useful based on your financial goals and objectives. 

How do derivative warrants work? 

Derivative warrants are financial instruments issued by financial institutions. They’re tied to underlying assets like commodities, currencies or stocks and come with a fixed strike price and expiration date.  

With this instrument, investors have the option, but are not obligated to, buy and sell an underlying asset at a fixed price before a specific date. 

When the market is favourable, investors can choose to buy low and sell high and thereby make a profit. 

Derivative warrants are traded on the stock exchange. Unlike other instruments, it does not compel investors to take action. It’s known as a versatile tool in the world of finance as it gives you the option to use it or not, based on your investment objectives and the market outlook. 

Types of derivative warrants

With derivative warrants, there are two main types. Let’s dive deeper into the two, see what they are and how they work. 

1. Call warrant 

One of the most common types, call warrants, give the holder the right to buy the company’s stock at a predetermined price prior to the warrant’s expiration date. Typically, this date is further out in time, sometimes up to 15 years. 

Most often, call warrants come into play by investors when the strike price (the predetermined price) is lower than the stock’s current market price.  

For example, say you can buy Company A’s stock at a fixed price of Rs. 2000 and the expiration date is eight months away. In these eight months, if the price goes over Rs. 2000 to say Rs. 3500, you can utilise your call warrant and buy the stock at a lower price of Rs. 2000 and sell it at a higher price of Rs. 3500, making a profit of Rs. 1500. 

Remember, you don't have to buy the stock if you don't want to. In the event the price of the stock remains at Rs. 2000 or doesn’t go over, you can let the warrant expire. This way you don’t lose anything. 

2. Put warrant 

With put warrants, you have the right to sell a certain number of shares back to the issuing company at a strike price.

To make this situation favour you, you want the stock market price to go below your strike price. This way, you can sell at a profit. Selling when the price of the stock is higher will result in you losing money.   

For example, you think Company B’s stock is overvalued, and you expect its price to go down soon. However, you are uncertain and don’t want to sell right away. Here’s where the put warrant comes into play. 

Using the put warrant, you can sell your stock at a fixed price, say Rs. 2000 before a specific date in the future. If the price drops to Rs. 1000, you can deploy your put warrant and sell it at the higher strike price, potentially avoiding a loss.

Akin to call warrants, you don’t have to sell. If you change your mind or the stock doesn’t go down, you can let the warrant expire. 

In essence, with call warrants, you bet on the rise of a stock without actually purchasing it while with put warrants you bet on the fall of a stock without actually selling it immediately. With both of these options, your investment strategy has both options and flexibility. 

Bottom line 

The world of stocks is like an ocean and derivative warrants are one of the many drops. 

This drop protects you from potential losses while also letting you enjoy speculating in the market. Thus, giving you the flexibility and precision to manoeuvre the stock market, all while catering to your financial goals. 

Now, you’re one step closer, armed with knowledge, to tackle everything derivative warrants have to offer. Remember, this understanding is just the beginning. To ensure you fully capitalise on the advantages of this instrument, you must proceed with caution, sound judgement, practical experience and a well-thought-out investment strategy.