Covered warrants give the ordinary investor an opportunity to knit a hedge fund from the safety and comfort of their own armchair. Launched in the UK in 2002 and traded on the London Stock Exchange, covered warrants are geared instruments, meaning that an investor can gain economic exposure to an underlying security with less capital than is needed to buy the security itself.

This approach exaggerates any gains, but it also amplifies losses – although
they do offer protection on the downside. ‘Compared with standard options, covered warrants are like a bike fitted with stabilisers,’ elucidates Clem Chambers, CEO at financial website ADVFN. He explains, ‘With an option, you can wake up one morning to find the underlying security has gone down the pan, which could cost you your house. With a covered warrant you can only ever only lose the original capital you invest. They’re a great way of getting unlimited upside but with a protected downside.’

Automatic stop-loss
It is a stop-loss mechanism that you do not have to remember to put in place, something that cannot be said for the alternatives such as spread betting. There are two types of covered warrants – puts and calls – which give the buyer the right, but not the obligation, to buy (calls) or sell (puts) a certain underlying asset, at a pre-determined price, on or before a pre-determined date.

Unlike shares, covered warrants have a limited life span – between three months and three years at issue – after which the cash value, (if positive) of the warrant is automatically paid to the holder. Warrants can be easily traded either online or by phone.

They offer the opportunity to leverage gains while limiting any loss to the initial investment and can be used to gain exposure to indices, currencies and commodities as well as individual shares.

A company issues traditional corporate warrants over its own shares and new shares are issued upon the warrant’s exercise (when you swap the warrant for a share). They are fairly illiquid and exclusively call warrants, which only give you the right to buy the shares on a specified date at a specific price.

The cover is the key
Covered warrants are issued by a bank or other financial institution over other assets, so no new shares are issued and you can hold not only call warrants (the right to buy the share) but also put covered warrants (the right to sell the share). Or, as Chambers says, ‘They’re a tradeable warrant issued by someone other than the company on whose share price the value of the warrant derives.’

Unlike a conventional corporate warrant, you do not pay stamp duty or income tax on covered warrants (warrants don’t qualify the holder for any dividends the underlying share might pay, although the dividends are a factor in the pricing of the warrant in the market) but their capital gains tax (CGT) treatment is the same as for ordinary shares.

However, it should be noted that the only current UK issuer of covered warrants is SG Warrants, a subsidiary of Société Générale (or Soc Gen as it’s usually known). The issuer is known as the counterparty and, as the only counterparty in the UK market, an investor is exposed to the risk of SG ceasing to be active in this market, although many brokers feel this is an unlikely scenario.

‘SG is actually ramping up its issuance of covered warrants,’ points out Amy Pal, associate director in active trader propositions at Barclays Stockbrokers.

‘It currently has around 800 listed on the LSE and by the end of the year it expects to have over 2,000. Since January it has seen a 30 per cent increase in its covered warrants business – and this is without any advertising.’

Comparing covered warrants with exchange traded funds (ETFs), Pal explains, ‘With an ETF, you’ll never get back more – or lose as much – as the underlying security, be it a company share, a commodity or a currency.’

‘With a covered warrant, you get geared exposure to a wide range of assets, you can profit from a bull or a bear market and your losses are limited to the original premium you paid when you bought the warrant. Although it is a growing sector in the UK, it is still a small part of the overall derivatives business – about two per cent.’

Covered warrants have not taken off here as dramatically as they have
in other European countries. ‘They’re extremely popular in Italy and Germany,’ says Clem Chambers. ‘But I think that in the UK there is an information gap about the product. Also, the British investment mindset is not about speculation – gamblers in the UK are already well catered for without ever going anywhere near the stock market.’

Indeed, because they are listed on the LSE, you have to buy covered warrants through a broker, which means opening an account before you can begin to trade. ‘Because one of the uses for a covered warrant is speculation and because it is a geared play, there is an element of inertia for an investor in registering with a stockbroker,’ says James Daly, investor centre representative at online stockbroker TD Waterhouse.

‘Investors are required to sign a risk warning notice before they deal. These are complicated financial instruments and the gearing, which is a major advantage of warrants, can also work against investors. If the underlying instrument to the warrant moves in the wrong direction, losses incurred will be greater in percentage terms.’

Complicated pricing
Warrant pricing is a complicated business, not least because one of the key factors of any market – the balance of supply and demand – has a negligible impact on pricing. Price determination is a sophisticated process, undertaken using algebraic techniques stiff with Greek letters and computer models. The five principal inputs are theunderlying asset price, volatility, time to expiry, dividend yields, and interest rates.

‘Basically, the price of a warrant is made up of two components,’ says Daly. ‘Intrinsic value is the amount the warrant would make you if you could exercise it immediately and time value is how long the warrant has to go before the expiry date. The longer the time to expiry the more expensive a warrant will be.’

Unlike with spread betting, where, if what you are betting on falls in price the downside gearing kicks in and you have to put up more margin or close out the position and settle your losses, with covered warrants, if the underlying asset moves in the opposite direction, all you can do is hope that the underlying asset moves the other way before the expiry date. ‘Which is why, on the pricing of a covered warrant, you pay a premium for time,’ explains Daly.

Choose your moment
Clem Chambers believes there are only ‘about three or four days a year’ when investors know which way a market, commodity or share will move. Covered warrants are an opportunity to back that hunch with no limit on upside gains but the knowledge their exposure to losses will only be as much as their original investment.

Chambers emphasises that covered warrants should only be approached when the investor investigated into the market. ‘There is a lot of information online and you should make sure you know what you’re doing before playing the market,’ he says.

He warns that ‘Like all financial instruments that are leveraged or geared, these are not toys or playthings and they require a degree of skill and sophistication from the investor. But, used with skill, sophistication and a bit of luck – they are a great way of backing your market hunches.’