Knock Out Certificate – Trading Tutorial

The first products with a knock-out structure came onto the market as early as 2001. These were therefore given the name “knock-out products”. Today, the various constructions have different names. These are for example turbo certificates, mini future certificates or turbo warrants.

Knock-out certificates arose from the fact that many traders had to make dissatisfied experiences with standard warrants at high implied volatilities. As a result, they were often too expensive and the movement of the underlying asset was only partially completed due to high time values. In addition, decreasing volatility has negative effects on price formation.

For this reason, knock-out products were created which offer investors the opportunity to speculate with a high degree of leverage and at the same time the implied volatility has hardly any influence. This created a new transparency in pricing and therefore these products quickly attracted a high level of interest.

Knock-out certificates explained

With knock-out certificates, investors can bet on falling and rising prices. These certificates are equipped with a barrier, also known as a knock-out threshold. If the price falls below this barrier, a total loss usually occurs and the product expires worthless. If the knock-out certificate contains a money-back element, a predetermined amount is paid out in the event of a knock-out.

Due to the risk of a knock-out, there are correspondingly high chances of winning, which are made possible by the high leverage. The closer the price is to the barrier, the higher the leverage.

Leverage is made possible by the issuer financing the part of the underlying asset that is not covered by the intrinsic value. For this part that the issuer has to finance, financing costs are incurred, which are offset by the premium.

In addition to the premium, a risk premium for possible gaps may also be due. Furthermore, there are also currency effects to be considered if the Underlying is quoted in a different currency than the Knock-Out Certificate.

What are the differences between knock-out certificates?

In the case of knock-out certificates, the maturity is one of the most important distinguishing features. There are thus products with and without a limited maturity (open end).

The term limit ranges from one day to several months. This means that every type of investor is catered for and can choose the term that suits them best.

There are also different variants with regard to knock-out trading hours.

There are products in which the knock-out barrier is only taken into account during normal trading hours, but there are also other variations in which the barrier is also taken into account before and after trading hours.

If the knock-out barrier is breached during the term, the certificate expires worthless. There are also knock-out products that have a built-in hedging level.

What tools are available for searching for knock-out certificates?

There are various tools for the search for knock-out certificates.

On the one hand, the respective issuers offer their own search functions so that you can choose the product that suits you best. Thus, it is possible to filter by market, maturity, base price, etc.

But there are also search tools that are independent of issuers.

The Stuttgart stock exchange, for example, offers such a tool.

What should you pay attention to when selecting knock-out certificates?

When selecting a knock-out certificate, various factors must be considered.

Firstly, you should make sure that you have chosen the right variation. This includes the underlying, the maturity and the knock-out threshold. With the knock-out threshold, it should be noted that there are products with and without stop-loss protection. This means that differences in risk tolerance can also be taken into account here.

In addition, the premium also plays a role in a knock-out with a limited maturity. Here too, there are differences between issuers and the financing costs included should therefore be compared carefully.

In the case of knock-out products without maturity, the financing costs are offset daily by adjusting the strike price. In the case of a long product, there is thus a slight daily increase in the underlying asset. If price changes are not taken into account, the intrinsic value of the product therefore decreases successively. Since these adjustments are determined by the underlying market interest rate and the financing margin estimated by the issuer, great attention should therefore be paid to the market interest rate and the financing margin.

Even small differences can lead to considerable differences in performance after a short time.

The spread should also be taken into account.

Investors should therefore compare the offers of different issuers and read the small print, which is described in detail in the product information sheet.

What is the product information sheet?

The product information sheet, or basic information sheet, provides all the key information on the product in question. In the case of knock-out products this means all the important details about the knock-out product. It contains all the information on a few pages, usually 2-3 pages.

However, this is not promotional material. Rather, these information sheets are required by law to help investors understand the nature, risk, costs, and potential gains and losses of this product. This also makes it easier for the investor to compare the knock-outs with other products.

If you are interested in how a product works in detail or if you are trading it for the first time, you should definitely read the product information sheet.

Also important here are the details regarding the underlying, maturity, expiration, etc. Only when you know all the details of the product can a trade be realistic. Many investors often overlook the small details, which can later be decisive for a profit or loss.

What risk classification are knock-outs assigned to?

The overall risk indicator, which can be found in the product information sheet, is used for the risk classification.

The overall risk indicator helps investors to assess the risk associated with this product in comparison with other products. It shows how likely investors are to lose money with this product because the markets are performing in a certain way or because issuers are unable to pay them out.

The risk class is rated on a scale of 1 to 7, with 7 being the highest risk class. The risk of potential losses from future performance is considered very probable.

If the issuer is not able to pay out what an investor is entitled to, the investor could lose the entire capital invested (issuer risk).

Does knock-outs also involve issuer risk?

As knock-outs are also leveraged products, they are also subject to issuer risk.

The investor bears the risk that the issuer may not be able to fulfil its obligations in relation to the product – e.g. in the case of
insolvency (inability to pay / over-indebtedness) or an official order for winding up measures.

In the event of a crisis of the Issuer, such an order of a settlement authority may also be issued in the run-up to insolvency proceedings. In this case, the Winding-up Authority has extensive powers of intervention. Among other things, it may reduce investors’ rights to zero, terminate the product or convert it into shares of the Issuer and suspend investors’ rights.

With regard to the basic ranking of the issuer’s obligations in the event of measures taken by the settlement authority, investors are referred to www.bafin.de and are requested to search for the keyword “liability cascade”. A total loss of the investor’s invested capital is possible.

The advantages and disadvantages of knock-out certificates

The advantages of knock-out certificates are manifold.

For private investors it is on the one hand the high leverage which allows large profits with small capital. Since volatility has almost no influence, there is a transparent pricing. In addition, it is now possible to speculate on all markets long and short.

Furthermore, knock-out certificates are suitable for day traders and swing traders due to the different variations.

High profits are usually associated with high risk. It is no different with knock-outs. When a knock-out is reached, there is a risk of total loss and the knock-out expires worthless, which is tantamount to a total loss.

In addition, as with all leveraged products, there is also the creditworthiness or insolvency risk of the issuer. This was the case with Lehman Brothers in 2008, for example.

For whom are knock-out certificates suitable?

Due to their high leverage, knock-out certificates are more suitable for speculative investors who have a concrete expectation of the performance of an underlying asset and would like to participate disproportionately in it.

How are knock-out certificates taxed?

Since the introduction of the final withholding tax in 2009, current income and capital gains are taxed at the final withholding tax rate of 25%. In addition to the final withholding tax rate, there is a solidarity surcharge and, if applicable, church tax.

Realised losses can be offset in full and for an unlimited period against all other gains from capital assets, such as fund income, interest, dividends, price gains, etc.

The final withholding tax rate therefore applies to all Certificates.

Does Comdirect also offer knock-out certificates?

Comdirect offers all warrants tradable in Germany and thus also knock-out certificates. It also has its own certificate finder.

Where can knock-out products be traded?

Knock-out products can be traded on exchanges or over the counter at the issuer’s premises. Depending on the broker, fees and brokerage fees are incurred when trading on the exchange. If you trade directly via the issuer, there is no brokerage fee.

Who are the largest issuers of knock-out products?

According to the statistics of the German Derivatives Association (DDV), Deutsche Bank is the issuer with the largest market shares in terms of market volume. Deutsche Bank has a market share of 18.20% or a market volume of 165,054,552 knock-out products traded.

It is followed by Commerzbank with a market share of 14.40% and DZ Bank with a market share of 11.55%.

  • The different names of the most common issuers

Due to the large number of issuers there are also different names for the knock-out products. Let’s take a look at the product names of the three largest issuers below (by market volume – status 09/2019):

  • German Bank
  • Commerzbank
  • DZ Bank

The knock-out products can be found at Deutsche Bank under WAVEs. There are different types:

  • DayWAVEs (1 day maturity)
  • WAVEs Unlimited
  • WAVEs XXL (unlimited duration with stop-loss mechanism)
  • X-WAVEs (unlimited duration on the X-DAX)
  • X-WAVEs Unlimited (Limited runtime on the X-DAX)

The knock-outs are listed at Commerzbank under the name Turbo warrants:

  • Classic Turbo warrants (limited term)
  • Unlimited Turbo warrants (Unlimited term)
  • Unlimited Smart Turbo warrants (unlimited term – barrier only relevant at the closing auction)
  • Unlimited BEST Turbo warrants (unlimited term – strike price and barrier are identical)
  • X-Classic Turbo Warrants (Limited term to the period 08:00 – 22:00)
  • X-BEST Turbo warrants (unlimited term to the period 08:00 – 22:00 – strike price and barrier are identical)

At DZ-Bank, the knock-outs can be found under Turbos:

  • Turbos (limited term)
  • Endless Turbos (Unlimited running time)
  • Mini Futures (unlimited term – strike price and barrier are not identical)
  • X-Turbos (Limited running time to the period 08:00 – 22:00)
  • X-Turbos Endless (Unlimited running time to the period 08:00 – 22:00)
  • An example of a current trade in a knock-out certificate

In the example, let us consider a trade in a Turbo Long on the share XY.

The purchase price is calculated from the difference between the current price of the XY share – the base price + the premium:

  • 100 € – 80 € + 2 € = 22 €

There are therefore three scenarios. Possible dividend payments are not taken into account here:

Scenario 1: Positive development of the share XY
The share is performing well and stands at €125 at the end of the term. This corresponds to a return of 25% before costs. The acquisition cost is 1% of the purchase price (22€ * 1% = 0.22€). The acquisition costs must also be taken into account for the share. These amount here to 1€ (100€ * 1%). This results in a yield of 24% (125-1)/100-1 = 0.24. The yield is calculated as follows: (price of the share at the end of the term – acquisition costs)/100-acquisition costs).

Taking the acquisition costs into account, the Turbo Long generates a return of around 81% (125-80+1-0.22)/22-1. This is calculated as follows:

(share at maturity – base price + acquisition costs – purchase price)/acquisition price – acquisition costs.

Scenario 2: Neutral development of the share XY
The share has a neutral development, i.e. the turbo is quoted at the end of the term at the amount of the purchase price + the acquisition costs. The turbo should therefore be quoted at €22.22 (€22 + €0.22) at the end of the term. The base value should therefore be €100.22.

Scenario 3: Negative performance of the XY share
If share XY reaches or falls below the knock-out threshold of €80, Turbo Long suffers a virtual total loss. As a rule, one receives 0.001€ per Turbo. This means that the share’s performance was -21% (80-1)/100-1 and you have lost 100% of your capital.

The example shows how the leverage can work in both directions.

Conclusion

Knock-out products are more suitable for speculative investors because of the high leverage and the risk of total loss.

Due to the transparent pricing and the almost non-existent influence of implied volatility, these products are easier to understand and also offer many advantages over traditional warrants.

In addition, knock-out certificates are now available on a variety of markets and underlyings, so that many trading ideas can be implemented here.

However, it is advisable to find out in advance exactly what the details and functionality of the products are and also to pay attention to the different names and variations of the issuers.

The product information sheet, which once again contains all the important details on the conditions, also serves this purpose.

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