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Riding the new warrant WAVEs!

The latest warrant to be released on ASX's Warrant Market is a type of knock-out warrant called WAVEs or Warrant Alternative VEhicles. Knock-out warrants are similar to other warrants in that they give you exposure to share price or index level movements but have a barrier or knock-out level attached to them. If the price of the share or value of the index reaches this level then the warrant will immediately terminate.

In this article we will look at these new warrants and consider the advantages and risks associated with trading them.

Signs of increased activity in Australia's equity markets are providing many trading opportunities for investors. Whether it is to gain exposure for the short-term or the medium to long-term, investors look for financial instruments that will enable them to efficiently trade a rising or falling market at minimal cost. Warrants, options and futures are commonly used in this fashion. 

In the past month ASX's warrants market has seen a new product innovation targeting investors with a short-term view. Knock-out warrants provide investors with a highly geared, low cost trading alternative to gain direct exposure to leading ASX listed companies and the ASX benchmark index ? S&P/ASX 200. They are issued as either calls or puts, allowing you to trade a rising or falling share price (or index). Warrant Issuers may differentiate their type of knock-out warrants by referring to them by brand name, such as WAVEs which are issued by Deutsche Bank AG.

What are Knock-out Warrants?
Knock-out warrants allow investors to gain exposure to the movements in a share price without having to invest the full amount required for the purchase of the underlying share. Investors pay the difference between the current share price or index level and the exercise price, plus a small premium. This price can be as low as 8% of the current share price. With minimal capital outlay and the ability for a warrant parcel to replicate the movements of the underlying on a cent-for-cent basis, it allows investors to leverage their returns.

What makes knock-out warrants different to options, futures and other types of warrants is that they contain a 'knock-out' or barrier feature, which is generally set at the exercise price. This means that if the share price or index level touches the exercise price (knock-out barrier) the warrant will automatically terminate. Investors will not be exposed to further economic downside risk, thus allowing the investor to reassess their trading strategy. Investors should be aware of this feature, especially when the share price trades close to the knock-out level. To find out the knock-out level, check the ASX website.

Advantages
Knock-out warrants provide many benefits to investors. Firstly, knock-out warrants are priced with a delta close to 1 (or 100%) per parcel. This means that as the share price or index level rises or falls, the warrant's price will reflect this change by increasing or decreasing in value by approximately the same amount, or 100% of that change. Simply put, knock-out warrants will track the underlying share price cent-for-cent per warrant parcel.

Investors can implement various strategies using knock-out warrants, such as trading a rising or falling market, or insuring a share portfolio against adverse movements in the sharemarket. If an investor held a bullish view, that is a view that the share price would rally in the short term, they could profit from this view by purchasing a knock-out call warrant. This gives the holder the right to buy shares at a fixed price, locking in a price today so if the share price did rise in value, the warrant would reflect that change by rising in value by approximately the same amount.

Alternatively, if an investor held a bearish view, that is a view that the share price would fall in the short term, they could profit from this view by purchasing a knock-out put warrant. This gives the holder the right to sell shares at a fixed price, locking in a price today so if the share price fell, the warrant would reflect that change by rising in value by approximately the same amount.

When knock-out warrants are issued over an underlying security, the Warrant Issuer will issue several calls and puts with different exercise prices (which is also the knock-out level), so investors should find that there will be a choice of knock-out warrants for them to buy into. As the share price approaches the knock-out level, investors generally exit out of their existing knock-out warrant and either crystallize their loss; or invest in another warrant with a knock-out level that is at least one step further away from the current market price.

Risks
Knock-out warrants provide many benefits to investors, however investors need to be aware that the knock-out or barrier feature can cause the warrant to expire early and without notice.

The value of these warrants can change rapidly so investors will need to closely monitor the price of the underlying and its proximity to the knock-out level of the warrant. As the underlying price gets closer to the knock-out level investors need to reassess their position and consider whether to rollout of the knock-out warrant and into another series where the knock-out level is further away from the current market price. The need to continually monitor this investment makes it even more important for investors to understand how the knock-out feature can impact the value of their warrant as they will need to respond to market changes that may threaten to trigger a knock-out event.

To find out more information about knock-out warrants and trading strategies, please view the links above or talk to your adviser.

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