Apart from the underlying price, the most important factor that affects the price of a warrant is implied volatility.
It is the expected volatility of the underlying in a given future period of time and is positively related to the warrant price.
When the implied volatility of a warrant increases, its price may go up.
When the implied volatility decreases, the warrant price may go down.
An example:
Stock A is currently trading at $10. The market expects that the range of fluctuations of the stock will be within $1 for most of the time in the future.
Stock B is currently trading at $10, and the market expects that its range of fluctuations will be within $5 for most of the time in the future.
What is the probability that stock A will climb to $20 within 6 months?
Which one, between Stock A and Stock B, will have a better chance of hitting $20 in 6 months?
Obviously, the answer is Stock B.
If for some reasons, the market expects a drop in the volatility of stock B (say from $10 to $1 in terms of the range of fluctuations) in a given period of time, then the price of a related warrant may go down as well.
This is due to the lower probability that the price of Stock B will exceed the strike price of the warrant upon maturity.
Hence, there is less chance for the warrant to be exercised upon maturity, and the investor will also have a less chance to get a higher return. As a result, the warrant price is likely to fall.
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