The recent sharp market correction will have proved a salutary lesson to complacent investors. Gains that may have taken months to build up can literally disappear in minutes if no remedial action is taken. One of the best ways to protect profits while still keeping much of the upside is via a hedge in the covered warrants market. These geared instruments are also ideal for capitalising on the volatile conditions.
A covered warrant gives the holder the right to either buy (call) or sell (put) an underlying asset at a predetermined strike price on or before the expiry date. Investors who are familiar with options will recognize the similarities, the main differences being that warrants typically have longer maturities and are available on a wider range of assets.
The UK covered warrants market is approaching its fourth anniversary and to date the five issuers between them have launched over 800 new products. These span a range of underlying assets and include: market indices, major UK and international stocks, currencies, and commodities.
Covered warrant trading has grown rapidly in the UK and last October the cumulative volume passed the £1 billion mark. March was the busiest month so far with a record 8,000 trades.
Christophe de la Celle from SG Securities, one of the issuers, says that covered warrants offer a simple and transparent way of gaining a leveraged exposure, while strictly limiting the downside risk to the initial investment. 'One of the more popular underlings in the past few months has been commodity warrants, as investors can gain a leveraged exposure to movement in the price of gold, silver, copper or platinum,' he says. 'New warrants on the CRB index, which is based on a basket of 19 commodities, have also recently been introduced.'
Like CFDs and spread bets, covered warrants will gear up the underlying returns and can be used to profit from both price rises and falls. Where they differ however is that warrants are limited liability instruments that are fully tradable on the stock exchange. This means that an investor can never be called upon to pay anything more than the original premium. The same is also true of Turbos (formerly knowno as Listed CFDs) and both are available through brokers such as Barclays, Squaregain and TD Waterhouse.
To help investors get the most out of warrants the LSE has launched a number of useful online tools at www.londonstockexchange.com/coveredwarrants. These include a 'scenario selector' and a 'hedging calculator'.
The first stage in selecting a covered warrant is to take a view on the likely direction of the underlying asset. A bullish outlook would imply buying a call warrant, while a bearish view could be implemented with a put.
Some assets will only have one call and put, but others like the FTSE 100 have a number of associated warrants all with different strike prices and maturities. The scenario selector tool is designed to help identify which of these will perform best in the different possible market conditions.
Take the example of an investor who believed that the market correction had run its course and who wanted to buy a call warrant on the FTSE 100 to capitalise on the recovery. The scenario selector identifies that there are nine such warrants with strike prices ranging from 5000 to 6500. These include lower-risk in-the-money securities, where the strike price is less than the current level of the market, to more speculative out-of-the-money products.
Richard Miller, manager of the active trader proposition at Barclays Stockbrokers, says that investors should be mindful of their trading plans when selecting which warrant to buy. 'Investors should have some sort of strategy in place and so will need to choose a warrant with an appropriate timeframe and level of risk,' he says. 'This will help to determine whether or not they go for something that is in-the-money.'
To find the most appropriate warrant using the scenario selector tool involves entering the forecast value of the underlying at a given point in time and specifying any change in volatility. With the index trading at 5677, a bullish view of a recovery to 5900 in 15 days' time at the same level of volatility suggests the most profitable warrant would be the highly geared out-of-the-money call with a strike price of 6500. If the forecast is right then the scenario tool calculates that this warrant would produce a return of 120%. Just as usefully, however, it also identifies less risky choices that would not be so costly should the market fail to recover.
Traders may find this useful in assessing not only which warrant to buy, but also where to place the stop. Oliver Hesketh, product manager of the online warrant tools at the LSE, says the most valuable part of the scenario selector is that it shows the possible downsides. 'People always focus on the upside but the scenario selector highlights the risks when things don't turn out as expected,' he says. 'This helps investors to make sensible decisions.'
Investors with established portfolios or profitable positions could protect their capital by hedging. The idea is to buy a suitable put warrant that would increase in value if prices fell to offset any losses. A put in effect guarantees the strike price, while the combination is such that it retains most of the upside potential.
The hedge calculator from the LSE helps to identify the most appropriate warrant and how many are needed. Take the example of a diversified blue-chip portfolio that could be effectively hedged using a FTSE 100 put (see table, page 56). Selecting the FTSE index and a portfolio value of £50,000 produces a list of six possible warrants. An investor who wanted to protect the 5500 level would choose the September put with the same strike price. The table shows the total value of the portfolio and the warrants under different scenarios using a static hedge. To protect a £50,000 portfolio entails buying 9,091 puts at a total cost of £1,563.64. No matter how far the index falls the overall loss would always be less than 5%, while if it rises most of the gain would still be available.
'The real value of the hedge calculator is in the table, which shows the range of possible outcomes for the combined position,' says Hesketh. 'It shows how on the downside the values reach a plateau, while there is still nearly a full participation on the upside. In effect, the hedge acts like an insurance policy and the key is to choose a strike price that equates to the desired level of protection.'
As with covered warrants, Turbos offer a geared exposure with the maximum potential loss restricted to the initial outlay. Both types of securities allow investors to make money from rising or falling markets and to hedge existing positions.
Turbos were first launched in October by SG Corporate & Investment Banking, part of the Société Générale Group. They are currently available on around 20 different underlying assets including various UK blue chips and the FTSE 100 index - see www.sgturbos.co.uk for full details.
When investors buy Turbos they are in fact acquiring an existing contract for difference. This is either long or short and has a predefined entry level, a notional level at which the contract was created. The long BT (BT.A) listed CFD for example has an entry level of 190p so, at time of writing, with the shares trading at 233p, each contract was worth around 43p.
All Turbos have a built in stop-loss, while the entry level also acts as a guaranteed stop, so investors cannot lose more than their initial investments no matter how badly the markets move against them.
De la Celle says Turbos now represent 10% of monthly securitized derivative trading on the LSE. 'One of the main advantages of trading Turbos over traditional CFDs is that there is a completely different take on risk,' he says. 'With a Listed CFD, the maximum amount an investor can ever lose on a trade is the initial investment whereas, if the market moves against investors with traditional CFDs, they can face additional margin payments and end up losing far more than the original investment.'
The value of this added protection was highlighted during the recent market correction. For example, the long ARM (ARM) listed CFD that was launched in April was actually stopped out in May with a payout value of just under 7p per contract
'Following the market correction, many traditional CFD traders faced very painful margin calls and ended up losing far more than their original investments as markets dropped severely,' says de la Celle. 'By contrast, long listed CFD traders saw their positions stopped out as shares prices dropped and hit the Turbos stop-loss level.'
The market falls meant that, while some of the long Turbos were stopped out, many of the shorts have made a good initial profit. BHP Billiton (BLT), for example, was launched on 27 April with an entry level of 1,375 and a stop loss of 1,250. At time of writing, with the share having fallen to 946p, each listed CFD was worth 432p, representing a gain of over 100% in under a month. 'In volatile conditions the in-built stop-loss could knock a listed CFD out of the market,' says Miller. 'The advantage of covered warrants is that they can survive extreme volatility.'