Covered warrants help you play the election

Kathleen Brooks
IF there is one thing that markets hate, it is uncertainty. With some polls pointing to a hung parliament after the election, many traders are tempted to take their money off the table until it is clear who is in charge of the British economy. If that means waiting until a second election – a likely outcome if the 6 May poll results in a hung parliament – then so be it.

Even in the City there is no consensus about how the financial markets will react to the outcome of the election. While some think that a hung parliament will herald huge problems for the UK’s economy, others think that it will weather the storm and the UK will bounce back later this year regardless.

Manoj Ladwa, senior trader at ETX Capital, says that markets are not so concerned about whether it is David Cameron or Gordon Brown who is walking through the door of Number 10 come 7 May, as long as there is no hung parliament. “A positive for the markets would be if there is a clear and decisive victory by one of the two main parties,” he says.

Others in the City believe that even a hung parliament might not be the disaster that some have predicted. Analysts at the consultancy Capital Economics wrote in a note to its clients: “The good news is that there is a broad-cross party agreement on the need to repair the public finances, so a hung parliament need not mean political gridlock. And even if the UK does lose its AAA rating, the market fall-out will probably be limited.”

So how can you navigate this uncertainty? Well, investors would be wise to invest with long time horizons and there are two trades that look attractive. Firstly, look to sterling. The pound has been the purest play on the outcome of the UK election in recent months. Sterling has fallen 10 per cent against the US dollar since the start of the year and is down 14 per cent against the euro since the collapse of Lehman Brothers in September 2008. Once election fever has died down and stability returned to the markets, then the pound seems over-due a correction higher.

Secondly, the FTSE 250 equity index – which is more representative of the UK economy than the more international FTSE 100 – should bounce if there is a Conservative victory in May. Traditionally, a Conservative government is considered better for the economy and therefore for business. During this election battle David Cameron’s party has positioned itself as the champion of the business world. This has increased recently after some of the UK’s most respected business leaders have come out in support of the Tories plan to scrap Labour’s proposed increase in the rate of national insurance. Due to this a Conservative victory would be perceived as a boon to the UK’s equity markets.

Covered warrants could be the perfect way to make these trades. Firstly, they limit downside losses, and secondly the expiry dates mean that you are effectively taking out options on future events after the election madness is behind us.

To be more specific, FTSE 250 call warrants are available from the Royal Bank of Scotland. It is offering call warrants with an expiry date of 17 June and a strike price of 10,000 (currently the index is trading at 10,426) and call warrants expiring on 16 December with a strike price of 11,500. You can also trade covered warrants on the FTSE 250 with Societe Generale. For investors with a long investment horizon and a positive outlook for the UK economy, then they may want to buy a call warrant with an expiry date on 16 December 2011 and a strike price of 12,000.
If you believe that after the pound’s battering in recent months it will move higher once the election is out of the way, then you might want to look at RBS’s call covered warrant for sterling-US dollar with a shorter expiry date of one month and a strike price of $1.6 (currently the currency pair is trading at $1.52) that should reap profits. Likewise, RBS also offers call covered warrants on sterling-euro, with expiry dates in June, September and December and strike prices of €1.4 for June and December and €1.2 for September. Another feature of covered warrants is that they are easy to trade and positions can be closed if the election doesn’t go the way you expect.

So, while nobody can read the future, that doesn’t mean you can’t trade it.