Vontobel Knock-Out Warrants


Knock-Out Warrant - what it is and what you can do with it

Knock-out warrants are gaining popularity among exchange change traded products. Maybe it would also be of your best interest to know what knock-out warrants are and what you can do with them.

Knock-out warrant is an term sometimes associated with uttermost complex investing products used by professionals only, but what is a knock-out warrant and could it also be used by private investors?

What is a knock-out warrant?

Knock-out warrants are derivatives that are exchange traded. The derivative means that the value of the knock-out warrant is tied to the performance of an underlying security e.g. stocks. Other underlyings include indexes and commodities.

To attain the knock-out warrant of choice one can use existing book-entry accounts. Thus, there is no need to register at the issuer. Thus, in practical terms it is nice to know, that knock-out warrants are exchange traded products that you can buy through your existing broker or bank.

As knock-out warrants are listed in the exchange, one can trade them like stocks. However, the price of knock-out warrants is not determined directly by trading at the market place, but are instead based on the price of the underlying security. There are two types of knock-out warrants, long and short. The price of the knock-out warrant long goes up as the price of the underlying security goes up. The price of the knock-out warrant short goes down, when the price of the underlying security goes down.

Derivatives are thought of as complex instruments, but the pricing of knock-out warrants is easy to understand and many private investors start using knock-out warrants, because of this clear-cut valuation.

The basics for understanding how knock-out warrants work, is to grasp the concept of knock-out level. The knock-out level corresponds to the strike price of options or warrants. In addition, knock-out warrants may include multipliers. The multiplier tells you how many knock-out warrants are needed for one underlying security.

In contrast, the value of knock-out warrant short goes up, when the price of the underlying security goes down. Please notice that the effects of dividends and interest are left out of the tables above. Because of paid interest, the final value of the product is slightly less than originally expected. The effect of paid interest is most easy to understand by studying the structure of knock-out warrants.


Vontobel Knock-Out Warrants 


The structure of knock-out warrants

Knock-out warrants are investment vehicles that contain loan.

  • Because of loan, knock-out warrants have a leverage effect. Thus, they yield potentially higher returns compared to stocks.
  • Because of loan, knock-out warrants have a knock-out level. In case the underlying stock even touches the knock-out level, the result is immediate expiration and complete loss of capital. In other terms, if you hit the knock-out level you lose your money.
  • There is no separate cost of interest that the investor must pay. Instead, the cost of loan is paid in the form of adjusted knock-out levels. Thus, interest is added daily to the knock-out level.
  • Owners of knock-out warrants do not receive dividend from the underlying stocks. Instead dividends are compensated for in the form of adjusted knock-out levels.

The existence of the knock-out level brings the investor the risk, that heavy volatility on underlying security causes the knock-out warrant to expire. In this case, the investor loses all his money.

However, on the positive side, the knock-out level ensures that the investor does not risk of losing more money than he invested in the first place. Thus, using knock-out warrants you may end up losing all your invested capital, but you will not end up losing more than you invested.

The market guarantee set by the issuer plays a central part in the trade for knock-out warrants. In guaranteeing the market the issuer commits to set a continuous buying and selling opportunity for the knock-out warrant in question. In other words, knock-out warrants should always be correctly priced in comparison to the prise of the underlying security.

How do knock-out warrants differ from warrants, options and unlimited turbos?

Knock-out warrants pricing mechanisms are somewhat similar to those of warrants and options. However, warrants are derivatives with expiration dates and a limited period of validity.

Knock-out warrants do not have an expiration date. In practical terms this also means that knock-out warrants do not have a time value.

Also, options have expiration dates. In addition, knock-out warrants differ from options in the form of gains. In case of options, one gains the possibility to buy or sell an underlying security at a certain price. In case of knock-out warrants you always get your gains in the form of cash.

Thus, in case of knock-out warrants, you will never run up into a situation where you would actually sell or buy the real underlying security.

Knock-out warrants do resemble mini futures. The difference is that the knock-out warrant has a single knock-out level that corresponds to both the strike price and the stop-loss barrier. In case of mini futures the stop-loss is higher than the strike price. As a result, knock-out warrants yield higher leverage compared to mini futures. On the other hand, in case of premature expiration mini futures still contain some residual value.

Knock-out warrants are also called unlimited turbos, so these two are the same.

How do knock-out warrants differ from bull and bear certificates in practical terms?

In addition to knock-out warrants, investors go for leverage using bull and bear certificates. The bull and bear certificates are best suited for short term investment, because volatility results in lower gains.

In case of knock-out warrants, volatility per se does not diminish gains. However, knock-out warrants run a risk of hitting the knock-out level. This is explained in the tables below.

Volatility eats up gains of bull and bear certificates.

The same effect can also lead to gains that are bigger than expected.

Knock-out warrants are easier to understand, because their price is not dependent on volatility. Interest expenses raise knock-out level and the value is derived form the difference between underlying security and knock-out level.

Please keep in mind, that these products are not suitable for all type of investors. knock-out warrants are complex financial instruments and require a good understanding for the underlying market and the product specific conditions and characteristics. When investing in knock-out warrants, there is a risk of losing your total invested amount. Please, consider among other risks; liquidity-, issuer-, market- and currency risk in your analysis when trading leverage products. Investors are responsible for reviewing all risk factors belonging to the products before investing, which are enclosed in the Base Prospectus and Final Terms & Conditions at the issuers website.

This article is republished through permission and is originally published in Salkunrakentaja.


Influencing factors on the price of a Knock-Out Warrant


Risks of Knock-Out Warrants

  • Due to the leverage the investor has a theoretical unlimited upside participation but also has to face on the downside the risk of a total loss.
  • A Barrier Event occurs if the observation price touches or falls below the Knock-Out Barrier during the observation period. In case of a Barrier breach, the Knock-Out Warrant expires worthless immediately.