The Complete Guide to Derivative Warrant Investing: Understanding Call and Put Warrants and Managing Risk
Derivative warrants are a widely used leveraged product among Hong Kong investors. This article offers an in-depth look at call and put warrants, key pricing drivers, time decay, and practical risk management strategies.
TL;DR: Warrants (covered warrants) traded on the Hong Kong Stock Exchange are leveraged derivatives. They mainly come in two types: bullish call warrants (Call warrants) and bearish put warrants (Put warrants). Their prices are driven by three key factors—the underlying stock, implied volatility, and time value—and they carry the risk of losing your entire principal. You must fully understand how they work before investing.
Hong Kong is one of the world’s major warrant markets. Warrants offer leverage and are exempt from stamp duty, attracting many retail investors. However, warrant pricing is far more complex than stock pricing. Many investors have faced the puzzle of “the underlying stock went up, but the warrant didn’t.” The reasons often lie in implied volatility and time value. Starting from first principles, this article helps you grasp the core concepts of warrants.
What is a warrant?
“Warrant” is transliterated in Cantonese as “窩輪,” and its formal name is a covered warrant, issued by financial institutions and listed for trading on the Hong Kong Stock Exchange. According to the Investor and Financial Education Council (IFEC), a warrant gives investors a “right, not an obligation” to buy or sell the related asset at a preset exercise price on or before a specified date, and it is usually cash-settled at expiry. The underlying asset can be an individual stock, an index, a currency, or a commodity. The tenor is typically six months to two years.
Key differences between warrants and stocks
| Feature | Warrants | Stocks |
|---|---|---|
| Tenor | Six months to two years | No fixed term |
| Stamp duty | Exempt | 0.13% |
| Leverage | Yes | No |
| Pricing drivers | Underlying stock, implied volatility, time value | Primarily driven by supply and demand |
The two main types of warrants: Call warrants and Put warrants
Call warrants (Call warrants)
Call warrants are bullish instruments that give the holder the right to buy the underlying asset at the exercise price. At expiry, if the settlement price is above the exercise price, the holder receives the cash difference; otherwise, the warrant expires worthless and the principal goes to zero.
Put warrants (Put warrants)
Put warrants are bearish instruments that give the holder the right to sell the underlying asset at the exercise price. They can be used to hedge existing stock holdings or for directional trades when you are bearish. At expiry, if the settlement price is below the exercise price, the holder receives the cash difference.
Tip: Longbridge’s Investment Products include warrant trading in the Hong Kong market, and you can trade directly on the platform.
Understanding a warrant’s moneyness is important: for call warrants, when the underlying stock price is above the exercise price, it is in the money (ITM) and has intrinsic value; otherwise, it is out of the money (OTM) and has time value only, with no intrinsic value.
The three key factors that affect warrant prices
Underlying stock price and Delta
Delta (hedge ratio) reflects the theoretical change in a warrant’s price when the underlying stock moves by one unit. Deep ITM warrants have a Delta close to 1 and track the underlying more closely; deep OTM warrants have a very low Delta and respond weakly to moves in the underlying.
Implied volatility
Implied volatility (IV) is the market’s expectation of the underlying asset’s future volatility and a key indicator of whether a warrant is “expensive or cheap.” The higher the implied volatility, the more expensive the warrant. If the underlying stock rises while implied volatility falls sharply, the effects can offset each other, and the warrant may fail to rise—or even fall. Some traders monitor a warrant’s implied volatility level to assess its relative volatility risk.
Time value decay
A warrant’s price includes time value, which represents the cost of holding the right to exercise in the future. Time value continually declines as time passes and goes to zero at expiry. The closer the expiry date, the larger the daily time-value decay.
Important note: Time value is one of the main costs of holding warrants. If you hold deep OTM warrants for a long time when they are close to expiry, your principal will be continuously eroded by time decay—so be especially cautious.
How to select warrants: a three-part screening framework
Some traders use the following three angles for an initial screen:
1) Exercise price: Some traders prefer warrants with a smaller gap between the exercise price and the underlying stock’s current price. Deep OTM warrants have a very low Delta and are not very sensitive to moves in the underlying.
2) Expiry date: Some traders avoid warrants that are too close to expiry, so there is more room for the price move to play out.
3) Outstanding quantity (street interest): When the outstanding quantity is too high, liquidity may be affected during periods of market volatility, so some traders monitor the outstanding quantity level.
You can use Longbridge’s analytics tools and market data to track warrant information and make better-informed decisions.
Key risks of warrants
Warrants are high-risk derivatives. Key risks include:
- Principal loss risk: If the warrant is OTM at expiry, the holder loses the entire principal.
- Implied volatility risk: Even if the underlying stock moves in your favor, a drop in implied volatility can still lead to losses.
- Time decay risk: The longer you hold, the more time value is lost, with a particularly large impact on OTM warrants.
- Credit risk: If the issuer encounters financial problems, the holder’s interests may be adversely affected.
FAQs
Do I need a special account to trade warrants?
No. Warrants are listed on the Hong Kong Stock Exchange and can be traded with a standard securities account in the same way as stocks. Longbridge Securities provides warrant trading services, and you can trade directly on the platform.
How are warrants settled at expiry?
The last trading day is the fourth trading day before expiry, and they are automatically cash-settled after expiry. For call warrants, the settlement amount is (Settlement Price - Exercise Price) ÷ Entitlement Ratio; for put warrants, it is (Exercise Price - Settlement Price) ÷ Entitlement Ratio. If the warrant is OTM at expiry, the settlement amount is zero.
Are warrants suitable for long-term holding?
Because time value continually erodes a warrant’s value, warrants are generally not designed for long-term holding. If you have a long-term view on the underlying asset, some investors consider investing directly in the underlying stock or an ETF, as the holding costs and time decay differ significantly.
How do warrants differ from CBBCs?
Callable Bull/Bear Contracts (CBBCs) have a mandatory call mechanism (“knock-out”) and terminate immediately when the call price is triggered; warrants do not have a mandatory call mechanism, but they are more affected by implied volatility and time value. Both are high-risk products. For a deeper understanding of the CBBC mandatory call mechanism and how the strike/call price works, see Comprehensive guide to CBBCs。
Conclusion
Warrants provide investors with a leveraged way to participate in the market, but their pricing involves three major factors—underlying stock price, implied volatility, and time value—and is far more complex than ordinary stocks. Only by mastering these fundamentals can you assess warrant risks more rationally.
Which investment instrument to choose depends on your investment objectives, risk tolerance, market view, and level of experience. Whatever you choose, you must fully understand its mechanics, risk characteristics, and trading rules, and put in place a robust risk management plan. You can learn more via the Longbridge Academy or Download the Longbridge App to build your investing knowledge.
