Covered Warrants and Turbos – The Basics

Warrants are speculative derivative instruments (derivative as they are based on other financial assets like shares, commodities..etc) listed on an exchange (such as the London Stock Exchange) and their value depends mainly on the underlying shares or indices over which they are listed. Essentially they are options, which provide buyers the right but not the obligation to buy or sell the assets they’re based on at a pre-determined price or or before the expiry date of the contract.

Covered warrants have been available to European investors for some 20 years and are now a well expanded market widely recognised by retail traders. The product was first created by Societe Generale in 1989 and the first listed covered warrant was launched in 1993 in Paris. There are now more than 129,000 covered warrants listed in Germany alone with some 20 providers issuing the warrants. In France, covered warrants have also been soaring in turnover with more than €8 billion traded for the period from January to the end of October 2009.

Covered Warrants are geared instruments which means that they are able to turn a small percentage price movement in the underlying asset into a bit percentage return. However, unlike other derivative instruments such as futures, CFDs or spreadbets where your losses are potentially unlimited, the most you can ever lose on a Covered Warrant is your initial investment. Covered Warrants can be on diverse underlyings ranging from major indexes, equities (both UK and global stocks), commodities and forex pairs. They usually have fixed expiry dates usually ranging from 6 to 12 months but you can usually sell a warrant before its expiry date to lock in profits or cut losses. After which the cash value (if positive) of the warrant is automatically paid out to the holder.

Covered Warrants (aka as Turbos) have now been available to UK investors since 2002 but their adoption by retail investors has been somewhat limited, especially when compared to other European countries (just £300 million worth of warrants have been traded since the start of the year and there are now just 3 issuers compared to the original 8 issuers when covered warrants were first launched in the UK). What sets the UK apart from many other European countries is that we have long had a strong tradition of options and futures trading among private investors. This could be due to the fact that the over-the-counter market for private investors is a highly developed market in the UK. And what’s more, financial spread betting, which evolved out of sports betting, is illegal in many other European countries. So if Italians are using more covered warrants or contracts for difference, it may simply be the result of laws that ban them from using spread bets.

If CFDs or spread bets have never appealed to you, you probably won’t be easily convinced of the attractions of covered warrants. So comparing the features of the products is a good way of gauging whether covered warrants are for you. And that is the thrust of this section: to find out what covered warrants can do for you.

How do Covered Warrants and CFDs Compare?

What contracts for difference (or spread bets for that matter) and covered warrants both offer is geared upside. If Dixons shares rise by 5 per cent, a Dixons covered warrant could rise by 20 or 80 per cent, depending on the particular warrant. A spread bet achieves gearing differently, by allowing you to specify the amount of money you wish to gamble for a given movement in the price. CFDs on the other hand are traded like shares – so if you want to open a contract for differences positions you would be quoted in the same way as if a normal shares buy was taking place – i.e. say ‘1000 Dixon CFDs’

Both CFD and covered warrant issuers will hedge their exposure so that they make money regardless of what happens to the CFD or warrant. This means they have no interest in seeing you lose money and it also makes them secure financial partners.

But there the similarities end. Although covered warrants are free from stamp duty, unlike spread betting, any profits from warrants are subject to capital gains tax. This may be the deciding factor for some UK investors.

Upsides and Downsides of Covered Warrants

On the other hand, with a covered warrant, the potential downside is limited to the size of your initial stake – and the upside is unlimited. A spread-bet or CFD that goes wrong can end up costing you vastly more than your initial stake, and you may get a call from your broker asking you to pay money into your account to cover the losses that you have racked up. That said, you may be able to set up automatic stop-losses to close your spread-bet/CFD positions if you have lost more than, say, 20 per cent. Secondly, the fact that covered warrants are listed on the London exchange gives scope for better transparency of prices than when dealing with a market maker – with turbos, investors can easily compare products when making investment decisions.

A problem with covered warrants are that the prices of contracts are determined by a complicated formula connected to factors like ‘time-decay’ (remaining lifetime of a contract) and market volatility. This is unlike spread bets and CFDs where investors can immediately track their gains or losses by checking the prices of the securities (which directly mirror the underlyings).

You can spread-bet or trade CFDs on the fates of far more financial assets than you can with covered warrants – although the number of warrants in issue should grow dramatically in the coming years.

What are Covered Warrants?

It’s a good idea to treat the process of warrant definition as a glass of fine wine. Swallowing the whole lot in one great gulp can make you dizzy. It is better to sip. There is a lot to savour. Not only are warrants composed of a number of elements, but those elements vary markedly between differing forms of warrants, of which there is a broad array. And just as different wines are suitable for different drinkers, different tables, and different budgets, covered warrants offer equal diversity. There are:

• Call Warrants and Put Warrants.
• American-style warrants and European-style Warrants.
• Vanilla Warrants and Exotic Warrants.
• Stock Warrants and Index Warrants.
• Basket Warrants
• Currency Warrants and Commodity Warrants
• In-the-money and Out-of-the-money Warrants
• Cash-settled and Stock-settled Warrants.

However, like Puts and Calls in options trading there are two main types of covered warrants: the Call Covered Warrants (for rising markets) and the Put Covered Warrants (for falling markets) so as opposed to traditional share dealing you can speculate in either direction. Covered Warrants have a fixed expiry date which can be set from three to up to 24 months in the future.

Covered warrants naturally become more valuable if they give the holder the right to buy or sell an underlying asset at a profit. Thus if a call warrant gives the right to buy a share for 100p and the share rises to 130p, the warrant price will rise to reflect the profit. So basically with a call warrant you are speculating on the underlying asset moving up – your profit will be based on the difference between the actual market level and the strike price.

On expiry a call warrant will generate a cash payout dependent on how far the underlying market price has risen above a pre-determined level (referred to as the strike price). For a put warrant the reverse would apply – it will generate a profit based on how far below the strike price level the underlying market has fallen. Covered warrant prices fluctuate in line with the underlying market movement and a warrant can even be sold prior to expiry. Alternatively you can leave the warrant to expire at which point the contract will be settled.

Intrinsic Value and Time Value

A covered warrant has both an ‘Intrinsic Value’ and a ‘Time Value’.

Warrant Price = Intrinsic Value + Time Value

Intrinsic value is the value a warrant would have if it were to be immediately exercised For instance, if a warrant gives the holder the right to buy one share at 100p and that share is currently trading at 130p, the intrinsic value of the warrant would be 30p. But if the share price falls to 100p or even less, the intrinsic value of the warrant falls to zero as you would be better off buying directly in the market. A put warrant has intrinsic value when its strike price is above the market’s current level.

For a Call: Intrinsic Value = Asset Price – Strike Price
For a Put: Intrinsic Value = Strike Price – Asset Price

The Time Value represents the potential for a covered warrant to become in-the-money in the time left before expiry. For instance, even for a share price which is currently at 100p, there would still be some value in a warrant with a 100p strike price if it has two months left to expire. The longer a warrant has until it expires, the better as this allows you more time to be right. The Time Value of a covered warrant will be zero at expiry so in such cases it might be best to sell your warrant before expiry. As a rough estimate a covered warrant will lose 2/3 of its Time Value during the last third of its lifetime. Thus, the more Time Value there is in the Premium (i.e. the longer the contract), the better the probability for the warrant to end up in-the-money.

Other factors affecting the price of Covered Warrants include dividends, interest rates and implied volatility; implied volatility being the expected future volatility of the underlying market. The higher the volatility, the more expensive the Covered Warrant is likely to be as greater volatility increases the possibility that the Warrant will finish in-the-money.

Tips for Trading Warrants

• Always trade warrants with more than 3 months until expiration. This is due to the heavy time delay during the last 3 months of a warrant’s life.
• Covered warrants and turbos can have a gearing from 2 up till 40. Do not trade warrants with more than 6 times effective gearing. A warrant with a gearing of 5 times will move 5% for every 1% the underlying share moves (this is a lot already just imagine 10 or even 40 times!). The good thing here is that losses are always limited to your stake with (with covered warrants) but the upside is unlimited.
• Do not invest more than 20% of your portfolio in warrants.
• Use stop loss orders when trading warrants (this is valid for all geared instruments, not just warrants).
• Don’t let emotions influence your trading decisions; setting a stop loss order coupled with a take-profit limit order helps to take the emotions out of trading.

More simply, then, a warrant is a right to buy or sell an asset at a fixed price, on or before a specified future date.

Warrants are similar to options. Since covered warrants have an expiry date you need to understand that the time until expiry affects their pricing. Also, if a share moves after a covered warrant has expired you will not stand to gain from that price move because the covered warrant contract is no longer valid.

Covered Warrants also present opportunities for capital gains which make them an attractive medium for speculative investing, although they can be used to serve a variety of aims.

The Attraction of Warrants

Covered Warrants are quite flexible; they can either be used as a margin trading tool to magnify gains, for speculative reasons to take advantage of the narrow spread between the buy and sell prices or even for hedging purposes.

As mentioned already, there are many different types of warrants, but the common theme is that they enable investors to obtain exposure to the performance of the asset for a fraction of the price. This is called gearing. Instead of paying 100p for a share, warrants might provide the same profit potential for 20p, and this lower price means that their percentage gains (or losses) are greater. Gearing means that you get more bang for your buck.

In the above case, a 30% increase in the share, results in a 300% increase in the warrant – this is the effect of gearing.

And an advantage of covered warrants over traditional UK warrants, is that money can be made in a falling market by buying put warrants. Another example -:

Covered warrants can prove useful to play acquisition speculative activity where a sniff rumour of a bid can send the price of the target company soaring. Here you would buy a longer-dated call covered warrant so that any jump in price is not offset by the deterioration in time value of the warrant. The advantages of using a covered warrant over a spread bet or CFD here is that there are no overnight financing charges and your maximum liability is always fixed in advance, unlike the unlimited potential losses possible with spread bets or CFDs.

Note: We’ve highlighted above the main attraction of warrants, which is the gearing effect on performance. Remember, though, this gearing works both ways: it propels warrant prices up quickly, and can do the same driving them down.

Comparison between Corporate Warrants and Covered Warrants

UK investors may be familiar with traditional equity (or ‘corporate’) warrants, which have been listed on the Exchange for a number of years. There are several key differences between these warrants, and covered warrants.

The table below lists the main differences between the traditional corporate warrants and covered warrants.

As can be seen, some elements are different, and some are the same. The various aspects are explained at greater length throughout this course. But the point to note for now is that there are significant differences between the two forms of warrants.