Knock-out Warrants

Features

Knock-out Warrants, like warrants, fall into the category of leveraged products. The products are called “CBBC” (callable bull/bear contract) in Hong Kong and “KOBA” (knock-out barrier) in Korea. 

Knock-out Warrants are a type of structured product that tracks the performance of an underlying asset without requiring investors to pay the full price required to own the actual asset. Knock-out Warrants are issued with a specified expiry date, a strike price and a call price (or knock-out barrier) and can be knocked out before expiry (a mandatory call event).

They are issued either as call (bull) or put (bear) contracts with a fixed expiry date, allowing investors to take bullish or bearish positions on the underlying asset.

Key benefits

• Possible expiry prematurely if the stock price of the underlying asset undershoots (for knock-out calls) or exceeds (for knock-out puts) a certain barrier
• Easier pricing for the investor to understand than that of warrants due to less or no influence of implied volatility
• Little to no time value and possess greater leverage than comparable warrants
• Underlying assets are typically shares and indices in Hong Kong and Korea. 

How do they work? 

There are two types of Knock-out Warrants: call/bull contract and put/bear contract. The delta of Knock-out Warrants is generally close to or equal to one. Suppose other factors remain constant, a Knock-out Warrants price moves according to the underlying assets. The investor can enjoy the gearing effect of changes in underlying price through a small amount of investment. The products are called "CBBC"  (callable bull/bear contract) in Hong Kong and "KOBA" (knock-out barrier) in Korea.

One great characteristic of Knock-out Warrants is that apart from the strike price, it has a call price and a mandatory call feature. If the underlying asset's price reaches the call price at any time prior to expiry, the Knock-out Warrants will expire early and the trading of the Knock-out Warrants will be terminated immediately.

Type of knock-out warrants

Call/bull contract versus put/bear contract

The call/bull contract represents optimistic and the put/bear contract represents pessimistic on a particular underlying. Knock-out Warrants are typically available over stock and index underlying assets in Hong Kong and Korea.

Category R and Category N

Knock-out Warrants are mainly divided into Category N and Category R. The strike price and call price of Category N are of the same level. When Category N Knock-out Warrants is called before expiry, there will not be any residual value. For Category R, the strike price and the call price of Category R are different. When Category R is called before expiry, there is possible residual value upon the occurrence of a mandatory call event (MCE) but in the worst case, no residual value will be paid. The CBBC in Hong Kong are mostly Category R and the KOBA in Korea are all Category R.

Trading Knock-out Warrants investment cycle

Key risks

Some of the risks of investing in Knock-out Warrants include:

• When the underlying asset price is close to the call price, the price of a Knock-out Warrants may be more volatile and the bid-ask spread may widen
• A Knock-out Warrant is called or knocked-out before the expiry, investors will lose most or all of the initial principal. The Knock-out Warrant is terminated and will not be benefited by any subsequent bounce in the underlying price (in the case of bull contract).
• Riskier than comparable warrants due to the possibility of "knock-out"