Want to take a punt on whether an equity rises or falls? Sure, you could buy a share and watch it drift up and down but why not speculate on its future fluctuations, asks Simon Read

Seasoned investors know that risk equals reward, and the bigger the risk you take, the greater the potential reward you may get. That's the main attraction of covered warrants. In simple terms they allow you to bet on future movement of a share - either up or down - and turn small movements into big gains.

‘The gearing you get through covered warrants can be a positive as investors only need to invest a fraction of the price to get exposure to the underlying investment, for example £10,000 invested in the covered warrants of a FTSE tracker would give you equivalent to £100,000 exposure," explains Adrian Lowcock, senior investment adviser at Bestinvest.

Gearing is an interesting concept. The level of gearing shows how much the covered warrants' price will theoretically move in response to a change in the price of the underlying equity. So if the share price is 100p, a covered warrant issued on that share may trade at 20p, giving a gearing of five times. The net effect will be that a small price movement in the share will be geared up to a large movement in the covered warrant.

That's brilliant if your punt is right and the share moves in the direction you gambled on. But if you guess wrong, the gearing means you'll quickly lose all your cash. You can, of course, be bearish and bet on an equity going down. If you want to gamble on that you'd buy a put covered warrant, as opposed to a call covered warrant if you had a bullish approach to the underlying equity.

Not for the fainthearted

Covered warrants can look tempting given the increased potential upside, but they're only for sophisticated investors who understand what they're getting into, experts warn. ‘Covered warrants only suit experienced investors and potential hedgers and speculators,’ says Peter McGahan of Worldwide Financial Planning. ‘The fact that a  warrant's price can drop to zero leaving the investor with no  redemption value means an investor in a warrant would have to really understand market movements and the stock they are speculating with.’

Lowcock agrees, ‘My view is that covered warrants are only suitable for experienced investors who have thoroughly researched the products. While they offer an attractive way to enhance performance or reduce the volatility of a portfolio, they are more complex than the underlying investments and the risks of losing all the money you invested are much greater.’

Steep learning curve

Darius McDermott, managing director, Chelsea Financial Services also points to their complexity: ‘Covered warrants are not as simple as shares or even as traditional warrants. When you buy a share you are receiving a small portion of a company. Derivatives, such as covered warrants, are less straightforward, taking their value from another instrument and thus being one extra step away from the profits, assets, and true value of a company.’ 
 
Other disadvantages include the fact that warrants have no voting rights and only have a potential for capital upside, not income. He adds, ‘Another potential negative relates to the expiry date because there is a chance you will lose all your money invested if the warrant isn’t going to meet its price.

‘Expiry dates also introduce a time element to the pricing: the closer to the expiry date, the less sensitive to price movements the warrants are unless the value is very close to the exercise price.’

He points out that the calculation of a warrant price is determined by three factors - underlying share price, time to expiry and market volatility. ‘It thus makes it harder for investors to identify how the investment will perform," warns Lowcock.

Rising popularity

With all these perceived negatives, why are covered warrants popular  with some investors? That's simple. The gearing effect allows people  to buy into a huge potential gain, but only with the risk of a much smaller bet. It means you can hedge against a rising or falling market or gain exposure to the market at a fraction of the cost of dealing in the underlying asset. And that underlying investment doesn't have to be an individual share; it could be a basket of shares, an index, a basket of indices, or even commodities or currencies.

If you're attracted to that kind of speculation you can buy covered warrants through many well-known financial institutions, such as mainstream stockbrokers.

Simon Read is personal finance editor at The Independent