WITH investors continuing to fear that the rally in stock markets could be over-extended and that a dip could be on the cards, covered warrant can be used as an efficient hedge tool of existing shares positions.<br /><br />Depending on what underlying they have and what precisely they fear might happen in the coming weeks and months, investors can choose a specific put warrant to hedge themselves against another downturn. For example, if you hold a diversified portfolio of UK large caps, you could hedge with a put covered warrant on the FTSE 100.<br /><br />As put warrants give investors the right but not the obligation to sell the stock at a predetermined price and on a set date, they will gain in value as the market falls. You would want to choose a put with a strike price close to the actual market level, because if the strike price is too far away from the current value then your hedge won’t be as powerful. It can be preferable to select a put warrant with a maturity that is three to four times longer than the length of time you think it will take for your fear to be realised. This means you will avoid the accelerated erosion of the warrant’s time value as it nears expiry.<br /><br />The most important aspect of hedging is to calculate how many covered warrants you should purchase in order to hedge your existing position as effectively as possible.<br /><br />To do this, you need to divide the value of your portfolio by the strike price of the desired warrant and then multiply it by the parity – the number of warrants required to theoretically gain exposure to one unit of the underlying asset. The parity for each share is shown when you choose the warrant.<br /><br />For instance a put warrant with a strike of 5,000 and a parity of 1,000 would require an investor with a £100,000 portfolio to purchase 20,000 warrants at the current market price. Of course, if you change your mind and no longer think that the market will suffer a downturn then you should sell your put warrant as soon as possible because your warrant would expire worthless and eat into your profit in your other positions.