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Education

Financial Terms and Definitions

Capital Pool Companies

For private companies looking to take their company public, a Capital Pool Company (CPC) provides an excellent alternative to the traditional IPO. The CPC Program provides a proven process and framework for introducing experienced investors to entrepreneurs whose junior growth companies are looking for both capital and management experience.
A Capital Pooled Company (CPC) is a clean shell company that is used by experienced investors to raise a pool of seed capital that will later be used to buy an operating business.
The mechanics of the process are relatively straightforward. The CPC conducts an initial public offering (IPO) to raise the needed seed money and after selling sufficient shares is permitted to list on the TSX Venture Exchange (TSX-V). Once the CPC is listed, it has 24 months to identify and acquire a qualifying target business.
The CPC Program is administered by the TSX-V and incorporates all the regulatory safeguards, which provides important protection for both investors and private business owners throughout the going-public process.

How does it work

Founding investors with business and public market experience put up a minimum of the greater of $100,000 or 5% of total funds raised which is used to incorporate a shell company which becomes the Capital Pooled Company (CPC). The CPC issues “seed shares” to the founding investors, which are priced at the greater of $0.05 or 50% of the price at which the IPO shares will be offered.
The CPC prepares a prospectus outlining the intention of management to raise between $200,000 and $4,750,000 through the sale of additional CPC shares, and to use the proceeds to identify and evaluate potential acquisitions. This prospectus is filed with the appropriate securities commission(s) and the CPC applies for listing on the TSX-V.
The CPC’s IPO shares must be sold to at least 200 arm’s length purchasers, each purchasing at least 1,000 shares and the CPC must have at least 1,000,000 common shares issued and outstanding upon completion of its IPO. The maximum number of shares any one purchaser can purchase pursuant to the IPO is 2% of the offering individually or 4% in combination with its associates or affiliates.
The CPC enlists a qualified agent registered under the securities laws of the relevant offering jurisdictions and is a member of the Exchange. Upon closing of the IPO, the CPC is listed on the TSX-V.
Once the CPC has completed its IPO and becomes listed on the Exchange, it may negotiate and enter into a merger transaction with a privately held company or business, referred to as a Qualifying Transaction.

Earnings Per Share

Calculated by dividing a company's total after-tax profits by the company's number of common shares outstanding. This can be used as an indicator of growth and profitability of a company, generally the higher the earnings per share (EPS) the more profitable the company.

Market Capitalization

Market Capitalization is a measure of the total market value of company. Calculated by multiplying shares outstanding by the stock price.

Example:

If the total shares outstanding of a company are 78,000,000 and the stock price is $1.25 a share than the value of the company is (78,000,000 X $1.25 =$97,500,000)

Understanding Options

A stock option is the right to buy or sell a stock at some point in the future. It’s a contract between two people to do something with a stock at a future price. This future reference price is called the strike. Since it’s a contract, an option can expire at its expiration date – the point after which the option becomes worthless if it isn’t exercised.

I’ll give you an example. Let’s say you want to buy a certain stock – ABC – in the future. You want 100 shares, and want to buy ABC at $10 (your strike price). Right now, ABC is at $8. You want to wait until the end of the month before you buy, so you buy an option to purchase 100 shares of ABC by the end of the month for $10. This is called a call option – the right (but not the obligation) to buy a stock.

What happens with this contract? Well, if the stock price goes past $10, you’ll profit because you’ll buy 100 shares at $10 – per the terms of your contract – and then sell them for whatever the market price is. If the price is $11 when you sell, you’ll make $1 profit per share, for $100 total.

If the stock price never gets past $10, and stays at, say, $9, you of course wouldn’t want to buy because you’d take an automatic loss of $100 when you sold.

 

Option Type

The two types of stock options are calls and puts. Call options gives the buyer the right to buy the underlying stock while a put option gives the buyer the right to sell the underlying stock. them.

 

Strike Price

The strike price is the price at which the underlying asset (or stock) is to be bought or sold when the option is exercised. It's relation to the market value of the underlying asset affects the value of the option and is a major determinant of the option's premium.

Premium

In exchange for the rights conferred by the option, the option buyer has to pay the option seller a premium for carrying on the risk that comes with the obligation. The option premium depends on the strike price, volatility of the underlying asset, as well as the time remaining to expiration.

Expiration Date

Option contracts are wasting assets and all options expire after a period of time. Once the stock option expires, the right to exercise no longer exists and the stock option becomes worthless. The expiration month is specified for each option contract. The specific date on which expiration occurs depends on the type of option. For instance, stock options listed in the United States expire on the third Friday of the expiration month.

Option Styles

There are 2 types of option contracts, either an American style or a European style option contract. The manner in which options can be exercised also depends on the style of the option. American style options can be exercised anytime before the expiration date of the option while European style options can only be exercise on the expiration date of the option itself. All of the stock options currently traded in the marketplaces are American-style options.

Underlying Asset

The underlying asset is the security which the option seller has the obligation to deliver to or purchase from the option holder in the event the option is exercised. In the case of stock options, the underlying asset refers to the shares of a specific company. Options are also available for other types of securities such as currencies, indices and commodities.

Contract Multiplier

The contract multiplier states the quantity of the underlying asset that needs to be delivered in the event the option is exercised. For stock options, each contract covers 100 shares.

The Options Market

Participants in the options market buy and sell call and put options. Those who buy options are called holders. Sellers of options are called writers. Option holders are said to have long positions, and writers are said to have short positions.

 

Call Option

Definition:
A call option is an option contract in which the holder (buyer) has the right (but not the obligation) to buy a specified quantity of a security at a specified price within a fixed period of time (until its expiration).

For the writer (seller) of a call option, it represents an obligation to sell the underlying security at the strike price if the option is exercised. The call option writer is paid a premium for taking on the risk associated with the obligation.

For stock options, each contract covers 100 shares.

Buying Call Options

Call buying is the simplest way of trading call options. Novice traders often start off trading options by buying calls, not only because of its simplicity but also due to the large ROI generated from successful trades.

A Simplified Example

Suppose the stock of XYZ company is trading at $40. A call option contract with a strike price of $40 expiring in a month's time is being priced at $2. You strongly believe that XYZ stock will rise sharply in the coming weeks after their earnings report. So you paid $200 to purchase a single $40 XYZ call option covering 100 shares.

Long Call

Say you were spot on and the price of XYZ stock rallies to $50 after the company reported strong earnings and raised its earnings guidance for the next quarter. With this sharp rise in the underlying stock price, your call buying strategy will net you a profit of $800.

Let us take a look at how we obtain this figure.

If you were to exercise your call option after the earnings report, you invoke your right to buy 100 shares of XYZ stock at $40 each and can sell them immediately in the open market for $50 a share. This gives you a profit of $10 per share. As each call option contract covers 100 shares, the total amount you will receive from the exercise is $1000.

Since you had paid $200 to purchase the call option, your net profit for the entire trade is $800. It is also interesting to note that in this scenario, the call buying strategy's ROI of 400% is very much higher than the 25% ROI achieved if you were to purchase the stock itself.

This strategy of trading call options is known as the long call strategy. See our long call strategy article for a more detailed explanation as well as formula for calculating maximum profit, maximum loss and break-even points.

 

Selling Call Options

Instead of purchasing call options, one can also sell (write) them for a profit. Call option writers, also known as sellers, sell call options with the hope that they expire worthless so that they can pocket the premiums. Selling calls, or short call, involves more risk but can also be very profitable when done properly. One can sell covered calls or naked (uncovered) calls.

 

Covered Calls

The short call is covered if the call option writer owns the obligated quantity of the underlying security. The covered call is a popular option strategy that enables the stock owner to generate additional income from their stock holdings thru periodic selling of call options. See our covered call strategy article for more details.

Naked (Uncovered) Calls

When the option trader write calls without owning the obligated holding of the underlying security, he is shorting the calls naked. Naked short selling of calls is a highly risky option strategy and is not recommended for the novice trader. See our naked call article to learn more about this strategy.

Call Spreads

A call spread is an options strategy in which equal number of call option contracts are bought and sold simultaneously on the same underlying security but with different strike prices and/or expiration dates. Call spreads limit the option trader's maximum loss at the expense of capping his potential profit at the same time.

 

Put Option

Definition:
A put option is an option contract in which the holder (buyer) has the right (but not the obligation) to sell a specified quantity of a security at a specified price (strike price) within a fixed period of time (until its expiration).

For the writer (seller) of a put option, it represents an obligation to buy the underlying security at the strike price if the option is exercised. The put option writer is paid a premium for taking on the risk associated with the obligation.

For stock options, each contract covers 100 shares.

Buying Put Options

Put buying is the simplest way to trade put options. When the options trader is bearish on particular security, he can purchase put options to profit from a slide in asset price. The price of the asset must move significantly below the strike price of the put options before the option expiration date for this strategy to be profitable.

A Simplified Example

Suppose the stock of XYZ company is trading at $40. A put option contract with a strike price of $40 expiring in a month's time is being priced at $2. You strongly believe that XYZ stock will drop sharply in the coming weeks after their earnings report. So you paid $200 to purchase a single $40 XYZ put option covering 100 shares.

Long Put

Say you were spot on and the price of XYZ stock plunges to $30 after the company reported weak earnings and lowered its earnings guidance for the next quarter. With this crash in the underlying stock price, your put buying strategy will result in a profit of $800.

Let's take a look at how we obtain this figure.

If you were to exercise your put option after earnings, you invoke your right to sell 100 shares of XYZ stock at $40 each. Although you don't own any share of XYZ company at this time, you can easily go to the open market to buy 100 shares at only $30 a share and sell them immediately for $40 per share. This gives you a profit of $10 per share. Since each put option contract covers 100 shares, the total amount you will receive from the exercise is $1000. As you had paid $200 to purchase this put option, your net profit for the entire trade is $800.

This strategy of trading put option is known as the long put strategy. See our long put strategy article for a more detailed explanation as well as formula for calculating maximum profit, maximum loss and break-even points.

 

Protective Puts

Investors also buy put options when they wish to protect an existing long stock position. Put options employed in this manner are also known as protective puts. Entire portfolio of stocks can also be protected using index puts.

Selling Put Options

Instead of purchasing put options, one can also sell (write) them for a profit. Put option writers, also known as sellers, sell put options with the hope that they expire worthless so that they can pocket the premiums. Selling puts, or put writing, involves more risk but can be profitable if done properly.

Covered Puts

The written put option is covered if the put option writer is also short the obligated quantity of the underlying security. The covered put writing strategy is employed when the investor is bearish on the underlying.

Naked Puts

The short put is naked if the put option writer did not short the obligated quantity of the underlying security when the put option is sold. The naked put writing strategy is used when the investor is bullish on the underlying.

For the patient investor who is bullish on a particular company for the long haul, writing naked puts can also be a great strategy to acquire stocks at a discount.

Put Spreads

A put spread is an options strategy in which equal number of put option contracts are bought and sold simultaneously on the same underlying security but with different strike prices and/or expiration dates. Put spreads limit the option trader's maximum loss at the expense of capping his potential profit at the same time.

Price/Earnings (P/E) Ratio

This is a theoretical measure of the value of a stock by dividing it’s current price by its earnings per share over the last twelve months.

When a stock's P/E ratio is high, it is considered by the majority of investors as pricey or overvalued. Stocks with low P/E ratios are typically considered a good value. This doesn’t necessarily apply in all circumstances and there are a number of other factors that need to be considered rather than just looking at a company’s PE ratio.

What is a Private Placement?

Private placement is a non-public offering of debt or equity securities to an individual or a small group of investors. This type of offering does not qualify as a public sale of securities, therefor there is no need for it to be registered with the Securities and Exchange Commission (SEC) and is exempt from the usual reporting requirements. Private companies use private placements as a way of raising money from the general public as its a cost-effective way for small businesses to raise capital without going public and since they do not require the assistance of brokers or underwriters, they are considerably less expensive and time-consuming. A private placement is also a way for small business owner to hand-pick investors with compatible goals and interests by structuring more complex and confidential transactions.

Relative Strength (RS) Line

A stock's Relative Strength line compares a stock's price performance versus the S&P 500 index. Many charting services plot a RS Line along with the stock's price, moving averages, etc. The line is derived by dividing the stock price by the S&P 500 Index value. An upward sloping line means that the stock's price is outperforming the S&P 500 Index.

Resistance and Support levels

These are terms used in technical analysis which shows the tendency of the price level of a stock to remain above or below a certain price level. When a stock moves above such a level (it’s resistance level) on high volume, it is sometimes viewed as a bullish indication, alternatively, when a stock moves below such a level (it’s support level) on high volume, it is sometimes viewed as a bearish indicator.

Return On Equity (ROE)

This is the amount of net income returned as a percentage of shareholders equity. Return on equity measures a company’s profitability by revealing how much profit a company generates with the money shareholders have invested.
ROE is expressed as a percentage and calculated as follows:

Return on Equity = Net Income/Shareholder's Equity

Net income is for the full fiscal year (before dividends paid to common stock holders but after dividends to preferred stock.) Shareholder's equity does not include preferred shares.
Also known as "return on net worth"

Reverse Takeover (RTO)

A Reverse Takeover occurs when a private company purchases a publicly traded company and moves its management and business operations into the newly acquired public entity. It allows the private company to become publicly traded while avoiding the regulatory and financial requirements associated with an Initial Public Offering (IPO). The cleanest way for a reverse acquisition to happen smoothly is to have the publicly traded company as a shell corporation, that is one with only an organizational structure and little or no activity. The two businesses can then merge the private company's assets with the public company’s structure. This also makes initial trading of securities less dependent on market conditions which sometimes can be a key risk in an Initial Public Offering (IPO).

Stock Charts

Charts allow you to get a good sense of the way a stock is trending and allows you to identify patterns, entry points and exit points.

Reading Charts – Technical Analysis.

With fund managers and institutional investors accounting for 80% of all trading activity, it is important to understand where allot of their decision making comes from. Their decision to buy or sell ultimately is what pushes your stock up — or down. The goal around understanding how to read charts is to give you a better understanding of when these institutional investors are aggressively buying or selling a stock.  Understanding what to look for allows you to quickly recognize when a stock is being aggressively bought or sold and allows you to use that information to determine the best time to buy or sell.

A chart is a visual representation of changes in share price and trading volume. Charts help you eliminate, headlines, rumors, hype and shows you what is really happening.

Daily Chart

Daily Chart

 

Weekly Chart

Weekly Chart

 

Weekly Chart Highlight

  1. Price: The price area shows daily changes in the price. The vertical bars in the price area of the daily chart show the share price range for that day. The small intersecting horizontal dash within the price bar indicates the current price or where a stock closed at the end of the day. The color of the price bar represents whether the stock closed up (blue) for the day or down (red) for the day.
  2. Volume Bars: The vertical bars in the volume area indicate the volume (i.e., number of shares traded) that day. As with the price bars, the color of the volume bar represents whether the stock closed up (blue) for the day or down (red) for the day. In the volume area, the red line shows the average volume for that stock over the last 50 days.
  3. Moving average lines: This horizontal red line tracks the average share price over the last 50 days of trading. This horizontal back line tracks the average share price over the last 200 days of trading.
  4. Relative Strength line: This line compares the price movement of that particular stock to the price movement of the S&P 500 (which is often used to represent the overall market). If the line is trending up, the stock is outperforming the S&P 500. If the relative strength line is trending down, it tells you the stock is lagging the overall market

 

Key Price and Volume Indicators to Watch

Look for Unusual Volume: As you go through the scenarios below, understand that you're looking for unusual volume — either unusually heavy or unusually light. That's what reveals what fund managers and other large investors are doing at critical moments, such as when a stock breaks out of a base pattern or falls below a moving average line.

For example, if a stock that normally trades 2 million shares a day all of a sudden trades 4 million, you need to pay attention. That's a sign of unusual institutional trading and you need to understand what story it's telling.

Intraday Trend: If you check during the trading session while the market is still open, "Volume % Change" shows you if volume is trending higher or lower based on the amount of trading so far that day or week.

Big price gains on unusually heavy volume show institutional investors are buying aggressively. It's also a bullish sign when the stock's closing price is in the top part of the price range for that day or week.

Let's take a look at the stock chart for ABC Technologies. The price increase on heavy volume signaled institutional buying when the stock broke out in August 2012:

ABC Technologies

Daily Chart

Daily Chart_ABC

  1. Big gain on heavy volume: The stock rose over 3% for the day on volume 108% higher than normal — a sign that institutional investors were scooping up shares.
    The price range for the day was from 40.35 to 42.00, and the stock closed at 41.96, the top of the range. That shows enthusiasm for the stock continued throughout the trading session.

 

  1. Lower volume on down days: After several days of heavy-volume buying, the stock had a couple of down days. But volume was lighter and mostly below average. By checking the volume, you could see the selling was not serious. That puts daily fluctuations in perspective and can give you the conviction and confidence to hold.

 

The same signs of strength can be seen in ABC Technologies' weekly chart:

ABC Technologies

Weekly Chart

Weekly Chart_ABC

  1. Big price gain on heavy volume kicks off big run. ABC Technologies rose almost 5% for the week, on volume 30% higher than normal — a sign of institutional buying.

The share price ranged from 39.73 to 43.00 for the week, and closed at 42.54. Closing at or near the top of the price range shows buying enthusiasm did not wane; it remained strong right through Friday's close.

Selling Signs - Big Price Drops on Unusually Heavy Volume

Big price drops on unusually heavy volume show institutional investors are selling aggressively. It's also a bearish sign when the stock's closing price is in the bottom part of the price range for that day or week.

Let's take a look at the signs of institutional selling on MNO Beverage’s daily chart:

 

MNO Beverage

Daily Chart

Daily Chart_MNO

 

Big daily drops on heavy volume: MNO Beverage flashed multiple warning signs as it sold off on mostly rising and above-average volume for three consecutive days. Note how it also closed near the bottom of the price range each day. That action showed large investors were shifting into selling mode.

  1. Huge gap down on massive volume: After three straight declines, the stock gapped down to close over 23% lower for day and well below its 50-day moving average line. Volume was 834% above average. The gap occurred because there was so much selling pressure that the stock instantly dropped to a much lower share price than the prior day's close. Such behavior usually indicates large investors are trying to get out of the stock as quickly as possible.

 

  1. Light-volume up days show weak buying: The stock tried to recover from that sharp sell-off, but note how volume on subsequent up days was generally lighter than the volume on the earlier big down days. That showed sellers still had the upper hand, and there wasn't enough enthusiastic, heavy-volume buying to push the stock back up. So despite some head fakes along the way, Monster Beverage continued lower for the next 12 months.

 

The same signs of institutional selling are displayed on Monster Beverage's weekly chart:

MNO Beverage

Weekly Chart

Weekly Chart_MNO

  1. Big weekly drop on heavy volume: After rising from a split-adjusted price of 75 cents to over 68 from August 2003 to October 2007, MNO Beverage sold off sharply and crashed below its 10-week moving average line. The stock fell 29% for the week on volume 215% above average. That showed that large investors were dumping shares and marked a clear change in trend.

 

  1. More weekly declines on heavy volume: That big sell-off was just the beginning. Institutional selling continued as the stock dropped nearly 70% from its peak in 12 months. It's a good reminder of why it's important to use charts to spot early warning signs — and why you should cut all losses at no more than 7% - 8%.

 

Support and Resistance

The concepts of support and resistance are undoubtedly two of the major aspects of technical analysis. Learning to identify these levels makes it easier to decide when you should enter and exit a stock.

Support is a price level where the stock tends to find support when it's declining. In theory, it's a price level where demand (buying power) is strong enough to prevent the price from declining further. This means the price is likelier to bounce off this level rather than break below it. However, once the price has gone through this level, it is likely to continue dropping until it finds another support level.

Resistance is the opposite of a support price level. It is where the stock price tends to find resistance as it is going up. This is the price level at which supply (selling power) is strong enough to prevent the price from rising further. It's likelier for the stock not to break through this resistance level. However, once the price has passed this level, by a notable amount, it is likely that it will continue higher until a new level of resistance is hit.

The same basic factors help you decide whether to sell or hold. For example, if a stock finds support at a key benchmark, such as the 10-week moving average line, you may choose to sit tight. But if it crashes through that floor of support on heavy volume, it may be signaling that the stock could correct.

 

Support or Resistance at 50-Day or 10-Week Moving Average

It's very important to watch how your stock behaves around the moving average lines — particularly the 50-day line on a daily chart and the 10-week line on the weekly chart.

The reason is simple: Professional investors use these lines as key benchmarks. So you can see if fund managers and other big players are supporting or selling the stock by watching how it behaves around those key moving average lines.

Support: If institutional investors still have a positive outlook on the stock, they'll often step in to buy more shares and protect their positions when the stock pulls back to or dips below the moving average line. In that scenario, you'll typically see the stock pull back to the 50-day or 10-week line on light volume (showing that institutions are not selling aggressively), then bounce back above that line on heavy volume (showing that fund managers are stepping in to buy more shares).

Sell-off: If the stock fails to find support at the benchmark lines and breaks below them on heavy volume, what does that tell you? That big investors may now be less interested in shoring up their positions and more interested in just getting out of the stock. Again, the key is to watch the volume: If trading is particularly heavy as the stock breaks through the moving average line, that's a definite warning sign. If volume is light, it could mean the selling is less serious.

Here is an example of how XYZ Inc. found support at the 10 week moving average line:

XYZ Inc.

Weekly Chart

Weekly Chart_XYZ

  1. Support at 10-week line: On the multiple occasions where XYZ Inc. pulled back to the 10-week moving average line (and 50-day line on a daily chart), it generally found support and stayed above it. On some occasions, the stock dipped below the 10-week line during the week, but managed to bounce back and close above that benchmark line by Friday's closing bell. That's a clear sign institutional investors are stepping in to support the stock and protect their positions. Watching for that support can help you sit through normal pullbacks and hold on for even bigger gains.

 

Sell-Off at 10-Week Moving Average Line

Watch out when a stock crashes through and closes sharply below the 10-week line on heavy volume. It could mark a change in trend and mean even more selling is on the way.

Let's take a look at the weekly chart for FGH Inc.:

FGH Inc.

Weekly Chart

Weekly Chart_FGH

  1. Heavy-volume sell-off at 10-week line: After rising over 390% in 20 months with good support along its 10-week moving average, FGH Inc. plunged below that benchmark on huge volume. It fell nearly 24% for the week on trading 190% higher than normal. That marked a clear change in trend, and the stock fell over 50% from its peak in eight months.

 

The price began to drop sharply on much heavier volume, a clear sign of institutional selling. Those warning signs appeared before the huge drop days earlier.

Support or Resistance at Specific Price Points

In addition to watching how a stock behaves around the moving average lines, you also want to look for signs of support and resistance at certain price areas. This is a vital part of understanding how and why the chart patterns discussed in the Buying section help you pinpoint the best time to buy a stock. And after you buy, this concept will also help you know whether you should hold the stock because it's building stepping stones by finding support at key areas — or if it's time to sell because it crashed right through the floor.

Resistance at Key Price Points

An area of resistance is a key testing ground: Make sure the stock can punch through it on heavy volume.

Let's take a look at DEF Corp’s strength after the stock broke through key price resistance.

 

DEF Corp.

Weekly Chart

Weekly Chart_DEF

  1. Resistance at same price area: DEF kept bumping its head around the 80 mark. On three separate occasions over several months, it hit resistance near that price point, then fell back down. Before buying, disciplined investors would wait for the stock to prove its strength by breaking through that price resistance on heavy volume. It finally did that in early January 2013, rising 17% for the week on volume 134% above average. From that breakout, Celgene rose over 110% in less than 12 months.

What are Stock Warrants?

A stock warrant is similar to a stock option. Just like options, warrants are issued as both calls and puts. A call warrant gives the holder the right, but not the obligation, to buy shares at a certain price on or by the expiry date. A put warrant gives the holder the right, but not the obligation, to sell shares at a certain price on or by a certain date.

The main difference between a stock warrant and a stock option is that a stock option is an exchange issued and traded financial instrument, whereas a stock option is issued by the company to which the warrant applies.

Companies often issue warrants when they issue new shares. They are a way of encouraging investors to buy the underlying shares, without the need for the investor to immediately part with the full cost of the shares. Over the lifetime of the warrant if the share price rises, then the purchase of the shares becomes more viable and the warrant value will increase.

Elements of a Stock Warrant

There are three main elements that determine the price of a warrant:

The Strike Price

This is the price at which the warrant allows the investor to buy the underlying shares. This will be the main driver of price of a warrant. For example, if a warrant allows an investor to buy 1 share at a price of $1.20, and the current price of the underlying shares is $1.50, then it’s fair to say that the warrant has an intrinsic value of $0.30.

The Expiry Date

All warrants are valid for a set period of time. The last day on which a warrant can be exercised is called the expiry date. The longer the time until expiry, the higher the price of the warrant: this is because the share price of the underlying stock has a greater time to move toward the strike price of the warrant.

The Conversion Ratio

This is the number of shares applicable to the warrant. For example, a warrant may be issued by ABC which gives the holder the right to buy one share for every four warrants. In other words, when exercising the right to buy shares, the warrant holder would have to ‘hand back’ three warrants – plus the strike price – for every share he is converting the warrants to.

Calculating the value of a warrant requires factoring in interest rates, time, exercise (strike) price, and conversion ratio. But, simply stated: the higher the price of the underlying share and the longer the time to expiry then the higher the price of the warrant.

Uses of Stock Warrants

You can use stock warrants to speculate on the price of the underlying stock, or to hedge an existing position. They can be freely traded, with registration transferred between holders, and as the cost is comparatively low they are attractive investments.

This low price means that the gearing on warrants is high. This means that the potential profit is higher than if an investor had bought the shares outright. But, so too, is the potential risk. Warrant prices tend to move in line with the price of the underlying share. However, because the price of the warrant is far lower, the percentage change is far higher.

To illustrate this, consider the following example:

ABC call warrants give the holder the right to buy one share per warrant at $1.00. The share price is currently $1.50. The price of the warrant is $0.50. (For the sake of this example we are discounting time value, and other pricing parameters.

If the share price rises to $1.70, the price of the warrant will rise to $0.70. The shares have increased by 13%, whilst the price of the warrant has increased by 40%.

However, if the share price were to fall by $0.25 to $1.25, the warrant will fall to $0.25. The shareholder has lost nearly 17%, but the warrant holder has lost 50%.

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