CFDs vs Warrants

CFDs versus Warrants

Q:What are Covered Warrants?

A: Covered Warrants (branded as the ‘turbo’ in the case of Soc Gen’s offering) have been available in Europe for almost two decades but have been introduced to the UK more recently. A warrant is an exchange traded derivative, analogous to ‘options’ – which are another financial product widely traded in the USA. ‘Warrant’ in fact is simply another word for option, while ‘covered’ means that they are issued by a financial institution. The term ‘covered’ originates from the fact that when the issuer sells a warrant, they usually follow this up by hedging their exposure by buying the underlying security in the market. Short-term traders can buy and sell covered warrants on an exchange (such as the LSE) to speculate on rises or falls in underlying assets such as shares, indices, currencies and commodities. Like options your risk is limited to the initial amount you invest. They are in fact very similar to an options except warrants usually cover more markets – for instance as well as share warrants there are covered warrants for indices, currencies and some commodities. Unlike options where you can theoretically take or effect delivery of the underlying instrument, covered warrants can only be exercised for cash.

Share warrants give the owner the right, but not the obligation, to buy or sell shares in a company using the warrants on a fixed date at a pre-determined price. These are called ‘calls’ and ‘puts’ respectively. A call is a way of betting on a rise in price. A put is a way of betting on a fall in price. Furthermore, if the warrants are quoted they can be bought and sold in a similar way to shares. Their value depends on the gearing element and is computed by comparing the exercise price against the underlying price of the shares in question.

Warrants come in two varieties – the call and the put. A call warrant gives the holder the right, but not the obligation, to buy an underlying asset at a pre-determined price on or before the expiry date. Thus, a call warrant usually rises in value as the underlying asset rises in value, as at give the right to buy the asset at a cheaper price (extracting a profit in the process). So a call warrant might allow you the right to buy stock in a company at a fixed ‘strike’ price of, say, £2.70 when the underlying stock is trading at £2.50. The warrant expires in 6 months (so you have 6 months to either use it or you would end up losing the premium). You pay a small non-refundable up front premium of, say, 18p per share. This warrant is said to be ‘out of the money’. This is because at the present time you are better off buying the shares in the underlying market for £2.50. Buying a call warrants would be a bullish prediction – should the stock price increase from £2.50 (within the 6 months) the warrant will similarly increase in value. So suppose it goes up 40p per share; you could sell the warrant and extract a profit of 20p per share (disregarding commissions and spreads) without ever buying the underlying stock. But not only that – your downside risk is limited to the 19p you paid upfront should the underlying stock fall which eliminates the need for stop losses (but remember that this still represents 100% of the amount invested). The reverse is true with a put warrant; this usualy rises in value when the underlying asset falls in value, as it give the right to sell at a higher price.

Covered Warrants Notes -:

  • Covered warrants are issued by financial institutions like Societe Generale, which maintain the buying and selling prices on the exchange, but they are traded through stockbrokers.
  • Covered warrants can be on diverse underlyings ranging from major indices, shares (both UK and global stocks), commodities and currencies. They usually have fixed expiry dates usually from 6 to 12 months.
  • Covered warrants contracts are cash-settled (unlike options) which means that investors cannot take or effect delivery of the underlying asset.
  • Covered warrants only allows investors to go long for an opening trade; one cannot sell warrants unless you are closing out a trade (this allows for their limited risk nature).
  • In a similar way to shares there’s a spread between the buy and sell price for a covered warrant. As with shares trading, you will buy at the higher price and sell at the lower price. The wider the spread, the less trading activity there is in the covered warrant.
  • Covered warrants are traded on margin which means that they are leveraged trades with maximum possible leverage of 50 times. However, using the maximum gearing is financial suicide; with 50 times gearing, a trader who buys a call warrants for instance would stand to lose 50% if the underlying dropped 1%! Gearing is derived from delta and takes into account the price of the option, the price of the underlying asset and the parity. The applicable formula is: Gearing = (Spot price x Delta)/(Parity x Premium).
  • When trading covered warrants you will come across the term ‘Parity’. Parity refers to the numbers of warrants that are needed to exercise over one shares. For instance, Next warrants have a parity of 10 which means that 10 warrants are the equivalent of exercising one share. The Parity ratio helps to reduce the covered warrant price to a more practical level for trading purposes.
  • The price of warrants is dependent on the underlying asset price, time to maturity, interest rates, dividends and implied volatility. The premium would include includes a fee for future volatility – i.e. when volatility is low covered warrants tend to be cheap and when volatility is high (the CBOE Vix index gives a rough indication) they tend to be more expensive (however, figuring out whether a warrant is cheap or expensive isn’t straightforward). Delta or sensitivity to a move in the underlying asset price is also another variable which in covered warrants should be 30% to 60% for a call, or -60% to -30% for a put (have a delta of 100% would be pointless as you could just as well buy the underlying asset).
  • Costs; in addition to the warrants premium, a covered warrant buyer pays a fee to their broker of approximately £12.50 when they buy or sell a covered warrant. Dividends are accounted for directly in warrant prices to eliminate arbitrage possibilities.
  • Covered Warrants are priced using the Black-Scholes option-pricing model. Warrant prices rise or fall faster than underlying asset prices since they are cheaper.
  • Covered Warrants come with credit risk – you are in fact exposed to the risk of the issuer in case of default.
  • For UK residents, warrants can be held in a Self-Invested Personal Pension (SIPP) but they cannot be included in the tax-efficient haven of an ISA.
  • Covered warrants are dealt through stock brokers in a similar way to shares; but they are free from stamp duty and are quoted on the London Stock Exchange. However, unlike spread bets covered warrants are liable to capital gains tax on profits, although that means losses on covered warrants are tax deductible.
  • If you hold a covered warrant to expiry, this will be sold automatically on the expiry date.

Example 1: Let’s say that in August, Barclays shares are currently trading at 150p and you want to speculate that the Barclays will rise considerably by the end of the year. You could buy a covered warrant with a strike price of 170p a share which expires on December. You would pay have to pay, say, 40p a share in this example (this is referred to as the premium). In the next few months Barclays shares have recovered strongly and are trading at 250p, so your covered warrant would be worth 80p a share [250p – 170p] since you could exercise the contract to buy the share at 170p and immediately re-sell the Barclays share in the market for 250p. If the share price were less than 170p on expiry, your covered warrant would expire with no value but the advantage is that you won’t have to pay more regardless of how much the share price of Barclays falls.

Example 2: Tesco shares are trading at £4.99. You believe the share price will fall so you buy a £5 put Dec 2009 warrant for 20p. The price of Tesco shares falls to £4.50 in December. The warrant allows you to sell a share for £5, but market price is £4.50. In practice, your broker will simply cash out your warrants for the difference (in this case 50p). If the price of Tesco shares had risen or stayed flat, your warrants would be worthless – but there is no other liability. Your maximum possible loss is limited to your inital outlay. Warrants can be traded just like shares, so they can be bought or sold at any time – and their market price tends to reflect the value of the share (but it doesn’t track it exactly – as the price of warrants varies in a complex way, depending on how much longer they have to their expiration date…etc.)

There are only a few market makers (notably Societe Generale, Goldman Sachs, Merrill Lynch and RBS) who create warrants for trading on the London Stock Exchange with Societe Generale (SG) and RBS currently being the biggest issuers. For instance, Societe Generale has more than 850 warrants quoted on the London Stock Exchange covering UK shares and indices as well as products based on US and Asian underlyings. There are also a number of currency pairs (last time I checked there were 6) and a number of tradable commodities. You can buy or sell these just like shares through a standard stock broker account (but be aware that not all stock brokers offer warrant trading. For instance Selftrade do offer them but Iweb don’t – and you may be required to submit a document where you acknowledge the risks inherent in derivatives trading before your broker will permit you to trade them). Other brokers offering covered warrants include Barclays Stockbrokers, TD Waterhouse and E*Trade (only deals in London Stock Exchange listed Covered Warrants).

P.S. A word of warning on Covered Warrants. The time decay (theta) element can really eat away the strength of it, apparently exponentially in some cases, such that a warrant ends up out of the money even if nothing else changes much, especially towards the end of the option. I’ve been burned by them after getting a bit cocky after a nice 60% gain in one day once, so do tread carefully and expiries well beyond your trade timing perspective!

Q:What is the difference between Covered Warrants and Turbos?

A: Societe Generale offers a type of product called Listed CFDs also referred to as a Turbo which is more like a covered warrant in a number of ways. In fact both Covered Warrants and Turbos are very similar however, Covered Warrants are medium and long term instruments, they offer different maturities from 3 to 18 months. Whereas Turbos usually have expiry dates of 3 and 6 months, and so are used for short to medium term market views. Covered warrant prices depend on the underlying price like turbos but they are also very sensitive to the volatility of the underlying.

Let’s take an example of a long turbo on BP with a strike price of 460p, a knock-out of 500p and 3 months to expiry. Assuming BP shares are currently trading at 550p and that the turbo is currently trading at 80p. If the stock were to rise 10p and the value of the turbo rises by the same amount, this would give a return of 12.5% (10p ÷ 80p) on your initial stake which is about the same return you would get from a regular CFD trade with a guaranteed stop loss level. A regular call option with a strike price of 460p would have cost more (thus lowering the over percentage return) but if the share price of BP were to whip-saw dropping down to a level below 500p, the turbo would have expired worthless, while the option would recover some value if BP later recovered to a level above 500p.

Covered Warrants allow investors exposure to a wider range of underlying assets such as UK and international equities, UK and global indices, currencies and commodities. Turbos have a somewhat shorter variety focusing on UK blue chip, and some indices (FTSE 100, CAC40, DAX and Eurostoxx50).

In terms of gearing, the Turbo price moves on an equal basis as the underlying (+1p/+1p). They also have a built in knock out barrier, which if hit the Turbo expires worthless (before expiry). Thus, unlike a conventional Covered Warrant, it doesn’t become valuable again if the share then rises back above that price (in the case of a call contract). A Covered Warrants price is affected by various factors, these are the underlying price, the underlying volatility and time to maturity.

Turbos also embed a knock-out barrier stop loss at no extra cost so that you can never lose more than your initial margin payment. It is possible to place stop losses on covered warrants however these are not guaranteed.

There are 4 main Market Makers for Covered Warrants, these are Societe Generale, Merrill Lynch, Royal Bank of Scotland and Goldman Sachs. For both Covered Warrants and Turbos the risk to the investor is limited to the amount invested.

Q:How do CFDs compare to Warrants?

What are the relative advantages of each when compared to each other? And what are the dangers of CFDs?

A: All covered warrants are exchange-traded unlike CFDs and can be bought via your broker using a normal share trading account. Covered warrants also have a pre-determined lifespan and a built-in stop-loss integrated into the contract, with the maximum you can lose being the initial amount invested for the contract (i.e. built-in limited risk). And they are also tax deductible like CFDs. You can also use covered warrants to gain leveraged exposure in a Sipp (but not in an ISA) and since warrants are exchange traded they benefit from the London Stock Exchange’s liquidity requirements. Lastly, covered warrants are not subject to stamp duty. Sounds good?

Unfortunately, there are also a few downsides. One of the most serious downside is complexity. Warrants have time decay, which is a negative unless you are in the money. Unless the warrant has a large, liquid market, you are still in the hands of the market maker as to the price you get/pay. The range of turbo contracts is also limited with Societe Generale being the main promoter trying to develop this product in the last few years – and pricing in the beginning wasn’t particularly competitive although it seems things are starting to improve and pricing has got better and with the availability of longer-dated contracts. In addition turbos also have stop loss orders and guaranteed stop-losses built into them and these act to prevent losses from gapping of share prices; however this also means that once a barrier stop level is hit the contract will end irrespective of the subsequent performance of the underlying. As opposed to covered warrents, turbos don’t recover in value if the share then rises above the strike price again. Of course the good thing about warrants is that you know how much you are exposed to. The same can be said to stop losses using a spread bet or normal CFDs; however here you can choose where to place the stop loss level and can move it after buying the contract. With turbos the stop loss level is fixed.

Let’s take the case of a long turbo on the FTSE 100 with a strike price and a knock-out level set at 5,400. With the FTSE level at 5,700, the turbo (aka as listed CFD) is quoted at 35p. The FTSE subsequently rises to 5,750 (rise of 1%) and the price of the turbo increases to 40p (an increase of 15% on your original investment). This amounts to about the same return you would get from a spread bet or normal CFD and a bit more that you would get using a normal option or covered warrant for the equivalent trade.

However, if the FTSE were to retrace below the 5,400 level, the turbo would expire worthless and you would not get anything, even if the FTSE subsequently recovered. This would still apply in the case of a conventional CFD contract but here you can choose where to place the stop loss level… With a turbo, you can’t since the stop loss level is fixed while with a covered warrant, your trade would also recover if the index rose above the strike price again.

CFDs are great for short term positions. No decay and if you play the large caps, you are mirroring the physical stock in every respect. However, you will have to enter/exit a trade on the market maker bid (unless you are using Direct Market Access), which most traders resent, but you can live with it.

So, I would argue that it is essential to fully understand the instruments you are considering, and that you develop the ability to assess the risk to reward proposition you are considering entering. That’s what using derivatives should be all about, minimising risk in context with maximising reward.

Sometimes a CFD will be the better alternative, but it is having the ability to assess which instrument is best based on the trader/investor’s style that ultimately separates the amateurs from the professionals. Another issue is that many people using CFDs don’t understand their real exposure. If you’re using a 5% margin for collateral, which means that you are borrowing 95% of the full amount the position is worth.

So, for example, let’s say you enter long $50,000 worth of XYZ stock in CFDs while it is trading around $10, so your margin requirement is $2,500. The (very) unwise would see this as them risking $2,500, where the $2,500 is a substantial portion of their trading capital. Let’s say that overnight a major negative news event happens, and the next morning the stock opens at $5.00.

You’ve just lost around $25,000 if your position is closed (which will happen if your account is not big enough to put up the margin required), but thought you were risking $2,500 if you didn’t understand the real nature of the exposure which was $50,000.

Just think about how many people may load up several positions like this thinking all they need to do is leverage $2,500 at a time. What if the market moved significantly against them? It is very easy to be exposed to over $100,000 of risk if you don’t know what you’re doing.

Even though strong moves like this are uncommon, they do happen, and they are a real risk. I know a trader who lost over $100,000 in this way in under a month because he didn’t manage his positions, and didn’t realise his real exposure. All you need is one major loss to wipe out months of good trading…think about it.

Ok, so there are guaranteed stop losses (GSL) available for CFDs which can be used to limit risk, but this is usually set at a maximum 5% loss in the underlying, and often has a fee to establish one, and for some providers a fee to move the stop loss as the underlying moves. This is certainly preferable to being totally exposed, but can still leave the trader/investor exposed to considerable risk. 5% for each large position can add up very quickly.

Another issue about CFDs is the exposure to having your account cleaned out. This happens if a position moves against you, and there are not sufficient funds available to cover the growing margin requirement. I’ve heard of CFD traders having their account cleaned out on an intraday spike, only to see the stock rally up past where it opened and continue on in their direction. But if the account can’t meet the margin requirements at any time, the position is automatically exited at a maximum loss to the account. This is a real problem if it is not managed, and in my view is a disadvantage to options/warrants.

Having said all that for short term market speculation, simply you cannot beat CFDs. CFDs are by far the more more common offering through most brokers and tend to offer the widest range of markets. However, one has to be aware of the leverage factor. If your stock goes down a lot, then you will lose a lot (assuming you’re long). Best way is to use caution using CFDs close to Annual General Mettings or close to profit announcements dates. You can gauge when these dates are on by monitoring the RNS dates. Of course, one cannot foresee a profit downgrade or a takeover announcement. Although, chart activity should alert you to an extent…

Q:What is the difference between Covered Warrants and Options?

A: The choice of markets is greater for conventional options than covered warrants and only a few providers issue covered warrants. Also, because there are more sellers, options do tend to be cheaper although the bid-offer spread for warrants is often tighter and more transparent (warrant prices are displayed on the Internet) which makes warrants attractive to short-term traders who want to trade in and out. Unlike options, with covered warrants you can only go long on an opening trade, you cannot sell warrants (go short) unless you are closing out a trade (this allows for their limited risk nature).

An advantage of covered warrants over options is that they are easily accessible from a regular stockbroker while the trading of options require a specialist options trading account (often requiring a minimum account size of some $10,000). Covered warrants are based on smaller amounts of the underlying asset; for instance options on UK shares are dealt in 1,000 shares but with UK covered warrants you can buy just 1 warrant which would be the equivalent of 1 share (since parity is 1:1). Moreover, long-dated warrants (with expiries of more than one year in the future) and far out-of-the money warrants (where the strike price is a long way away from the current price) tend to be more easily available than the equivalent options and these ‘qualities’ are often useful for hedging purposes.

Leave a Comment

Trade with HYCM! HYCM are a UK regulated MT4 and MT5 provider offering tight spreads and many markets to trade. Trade responsibly: 67% of people lose money when trading CFDs with this broker. Click Here!