If investors are to successfully participate in the warrant market, understanding the relatively specialised terminology is essential.

One good starting point would be the terms 'in-the-money', 'out-of-the-money' and 'at-the-money' since there appears to be confusion as to their exact meanings.

It is common, for instance, for investors to refer to a warrant as being 'in-the-money' if they had bought it for a lower price and can sell it for a profit.

Similarly, if the warrant falls in value, there is a tendency to say the warrant is 'out-of-the-money'.

In both cases, the terms are wrongly used.

They do not refer to whether the investor has made money or not or is sitting on a paper profit or loss; instead, they refer to where the warrant's exercise price is relative to the underlying asset's price.

Recall that call warrants give you the right (but not the obligation) to buy the underlying asset at a fixed price known as the exercise or strike price within a specified time frame.

From the viewpoint of the investor who holds a call, it is therefore in his favour if this right to buy is at a price lower than the underlying's market price because he can, in theory, exercise his right, buy the shares from the issuer and sell them in the market for a higher price.

So call warrants are said to be 'in the money' if they are written with exercise prices below the underlying's market price, or when the underlying's price rises above the exercise price.

Conversely, a call is 'out-of-the-money' when the underlying's price is either written or falls below the exercise price.

As for puts, recall that these instruments give the right to sell the underlying shares to the issuer at a fixed price. So a put holder wants the price of the underlying shares to fall below the exercise price because he can, in theory, exercise his put, buy from the market and sell the shares to the issuer at the exercise price.

The put is therefore 'in-the-money' if the share price (or underlying asset price) falls below the exercise price, and it is 'out-of-the-money' if the share price rises above the exercise price.

Finally, both calls and puts are said to be 'at-the-money' if the underlying's price is equal (or very close to) the exercise price.

Under what circumstances would it make sense to trade in any of the above types of warrants?

We'll answer this in future columns.

This column is brought to you by Merrill Lynch.

Please send your questions to btwar@sph.com.sg

This article was first published in The Business Times on 14 July 2008.