Learn the stock market › Short selling, warrants and leverage › Lesson 3 of 7

What is a warrant?

Short answerA warrant gives the right to buy or sell a stock or an index at a set price, much like an option, but it is issued by a company or a bank and traded like a stock. A knock-out follows the price with leverage and ends if the price reaches a set level. You cannot lose more than you paid.

Two kinds

An ordinary warrant works like a call or put option: the right to buy or sell at a strike price until an expiry date. Its price depends on the same things as an option's, and at expiry it is worth the difference between the price and the strike, or nothing. Unlike a listed option, it is issued by one party. When a company issues it, new shares are created if it is used, so existing owners' stakes shrink a little.

A knock-out (sold as turbos or mini futures, mostly in Europe) has no expiry but a financing level and a stop. You pay roughly the price less the financing level, and the issuer covers the rest. That is why your stake moves far more than the price. If the price reaches the stop, the product ends. What is paid back then is in the terms, and it can be nothing.

Work out a knock-out

With the price at $100 and the financing level at $90, you pay $10 for something that moves like $100. That is ten times leverage: if the price falls to $95, half the stake is gone. Change the numbers and see when the stop is reached.

Your stake, $Price now, $Financing level, $Stop, $New price, $

The leverage is 10.0 times. At a price of $95 your stake is worth $5,000, −50%. If the price reaches $92, the product ends.

An example with round prices, before fees.

How often is the stop reached?

A knock-out on the S&P 500 with its stop 5, 10 or 20% below the price. The share of three-month periods since Jan 3, 2000 in which a close reached the stop:

Level below the starting price	Reached the level within three months
5% below	36%
10% below	17%
20% below	4%

S&P 500, every starting day since Jan 3, 2000, 6,690 periods. Worked out on closing prices; prices during the day reach a level more often.

A stop 10% below was reached within three months in 17% of the periods, and one 5% below in 36%. Once the stop is reached the stake is gone, even if the index then turns up. Someone buying a highly leveraged knock-out needs not only the right direction but also a price that never goes too far the wrong way on the way there.

What can you lose?

A buyer of a warrant can lose what was paid, but no more. A warrant is also a promise from whoever issued it, so it is never safer than the issuer. Products where the loss can exceed the stake are in the lesson on leverage.

Test yourself

The index falls 12% and then rises 20%. What happens to a knock-out with its stop 10% below the starting price?