Covered Warrants - The Basics

Covered warrants: The basics

Covered warrants have now been available to UK investors for two years - and the market has taken off nicely, according to issuers and brokers.

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. 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, it may simply be the result of laws that ban them from using spread bets.

If spread betting has never appealed to you, you probably won't be easily convinced of the attractions of covered warrants. So comparing the features of the two 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 spread betting compare?

What spread betting 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.

Both spread-bet and covered warrant issuers will hedge their exposure so that they make money regardless of what happens to the bet 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 bettings, any profits from warrants are subject to capital gains tax. This may be the deciding factor for many of you.

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 that goes wrong can end up costing you vastly more than your initial stake, and you may get a call from your spread better 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 positions if you have lost more than, say, 20 per cent.

You can spread-bet 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. But, despite the wider range, most spread-bets are operational for a mere three months. You can only carry them over by closing the position (crystallising any losses) and reopening it. By contrast, the average covered warrant extends for a year - and even three years in some cases.

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:

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. They 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

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.

Example of a call warrant
A call warrant carries the right to buy one share at	110p
Current share price	100p
Current warrant price	5p
If the share price rises to	130p (+30%)
the warrant would rise to at least	20p (+300%)

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 -

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.

 Covered Warrants and Listed CFDs