Investors: You have nothing to lose but your premiums

BACK in 2002, covered warrants were launched on the London Stock Exchange with grand fanfare. And nobody cared. The products turned out to be something of a flop, with only £886,000 changing hands in the first week of trading. There is nothing intrinsically bad about covered warrants, however.

In fact, they are quite remarkable – they offer retail investors the chance to do what institutions do with options – speculate with high exposure on almost anything. As exchange rate volatility gets worse than ever, and commodity prices jump up and down like a kangaroo on crack cocaine, more investors might be wise to consider them.

A covered warrant gives the holder the right (but not the obligation) to buy or sell a specific amount of an equity, an index or another investment on a particular date at the strike price. Financial institutions, which take the actual delivery of the underlying product, issue them – meaning that no stamp duty is payable, although capital gains tax is. They can be linked to an incredibly wide variety of products, offering retail investors an easy way to speculate on some more exotic asset classes. Societe Generale, for example, offers covered warrants linked to the price of coffee or even cocoa.

And as with an option, investors can go long or short on an asset – placing a “call” covered warrant (an option to buy) or a “put” one (to sell) – without risking more than their original investment (the premium). If an investor’s bet goes sour, he can simply choose not to exercise the warrant, and at expiry it becomes worthless.

STRIKE PRICE

Barclays Stockbrokers offers this example. Say someone is bullish on FTSE 100 – they might buy 10,000 call covered warrants linked to it, paying a premium of £2,000, with a strike price of 5,660 and a maturity period of six months. 5,860 is the break-even price for the covered warrant, since a rise of 100 points is worth £1,000. If the FTSE rises above 5,860, he will make a profit. If, by the end of the six months, it is somewhere between 5,660 and 5,860, he will make a loss. And if it falls, he will lose his original £2,000.

Unless, that is, he decides to cut his losses by selling the product on the secondary market to someone more bullish. Even if a covered warrant is looking unprofitable, it might still have some time value left, since there is a chance that it might become profitable before it expires.

The more volatile a product is, and the longer left before the expiry date, the higher the time value is likely to be, and so the more the product should get on the secondary market. A covered warrant linked to a currency, for example, will probably be worth more than one linked to the FTSE 100, since currencies tend to be more volatile than equities.

Of course, there are some disadvantages to holding covered warrants, especially over the longer term. Holders do not get any dividends, which they might if they held actual equities. Similarly, the time value of a covered warrant falls quite quickly, which rules out playing a very long game.

But despite those annoyances, covered warrants are still a very good option for the retail investor who wants to speculate with lots of leverage and without risking an unlimited loss. It is about time they got more popular.

GLOSSARY | COVERED WARRANTS

Call Covered Warrant
Buy this when you’re taking a long view on the underlying asset and you expect the price to rise.

Put Covered Warrant
Buy this when you’re taking a short view.

Expiry Day
Covered warrants expire on a particular day. On that day, you have to decide whether or not to exercise the warrant.

Strike Price
The strike price is the price that the warrant gives you the right to buy (or sell) at.

Breakeven Point
The point where the difference between the strike price and the underlying price exactly equals the premium

In The Money
When a warrant is looking profitable, it is said to be in the money

At The Money
When the underlying price is at the strike price, the warrant is said to be at the money

Out The Money
When a covered warrant is making a loss (the call price is below the strike price, or the put price above it), it is said to be out the money