Covered warrants: another way to cap your risks

If the thought of running up hefty losses puts you off spread betting, covered warrants could be for you. Here's what you need to know.

Many traders like the potential for higher returns that leveraged investments such as spread betting or contracts for difference (CFDs) can provide, but are worried about the possibility of running up large losses.

This risk can be controlled with stop-losses, but some investors prefer not to have the complication of managing these, especially while getting to grips with leveraged trading for the first time.

Stop-losses may also see you knocked out of a position when the share price hits your stop, only to see the share reverse course, and the bet turn profitable if it had been allowed to continue.

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If you're in this position, covered warrants could be a useful alternative. These allow you to make leveraged bets, but limit your maximum loss to your initial stake.

They have a fixed expiry date although you can choose to sell beforehand and will remain in force up to that date, regardless of what happens to the price of the underlying share, so you won't risk being knocked out too early by a stop-loss.

Big returns from a small stake

A covered warrant is the retail version of what professional traders call an option'. Both give an investor the right to buy orsell a share, or another security, at a certain fixed strike price' ator by a fixed date in the future. There are two types of covered warrants: calls' and puts'. Calls give you the right to buy, puts give you the right to sell.

Let's look at an example. Say shares in Acme Widgets are trading at 100p. If you think the share price is going to rise by a lot, you might decide to buy a call warrant that gives you the right to buy 1,000 shares at 120p (the strike price) within six months, for 10p per share.

Say the share price then climbs to 150p per share just before the warrant's expiry date. You could now sell the warrant for a profit of 30p a share the difference between the market price of 150p and the strike price of 120p.

Deduct the 10p cost of the warrant (ignoring commissions and spreads), and that's an overall profit of 20p per share, or £200 a return of 200% on our initial stake.Alternatively, let's say you think that Ajax Services, currently trading at 200p, is heading for a fall.

You could buy a put warrant that gives you the right to sell 1,000 shares at 150p for 20p per share. If the price collapses to 100p, you would make a 50p profit (150p-100p) minus the 20p premium. That's 30p per share, or £300 overall a return of 300%.

Understanding the risks

The appeal of this kind of trade is obvious. The downside risk is capped at the price of the warrant. In the first example this was £100 (1,000 x 10p) and in the second example £200 (1,000 x 20p). So whatever happens, you can only lose the money that you paid up front.

However, it is very important to understand that if your bet is out of the money' when the warrant expires meaning that the share price is below the strike for a call, or above the strike for a put the warrant expires worthless and you lose the whole premium paid.

And the reality is that most warrants expire out of the money. So they are certainly not a low-risk instrument just one that offers a simple way to cap your risk, albeit at 100%.

Also, covered warrant pricing is quite complex (see below) so you should ensure you understand how this works before diving in.

However, covered warrants are relatively easy to use, since they trade on the stock exchange and can be bought or sold through most stockbrokers. So they can be a useful introduction to leveraged trading, as well as a useful tool in their own right for certain types of trades.

The main covered warrant issuer in the UK is Socit Gnrale, which offers a range of products covering major UK and international shares, stock-market indices, commodities and currencies.

What sets the price of a warrant?

The mathematics behind the pricing of options and warrants is complex and won the Nobel Prize for two of the academics who worked it out.

Most investors don't need to understand it in detail it's easy to find option calculation software online for working out what the price should be. However, knowing which factors go into the calculation and how they affect the price is important.

The first factor is the gap between the price of the underlying share and the warrant strike price: the more positive the gap, the more the warrant is worth (by positive, we mean the more the share price is above the strike price for a call, or below it for a put).

Next comes the time to expiry'. The longer the warrant lasts, the more it costs; all else being equal, the warrant's resale value will decline as it gets closer to expiry.

Then there's volatility. In a nutshell, the more volatile, or price sensitive, the underlying share, the more the warrant will cost.

Finally, there are two less important factors dividend yields (assuming the stock has one) and interest rates. Lower yields and higher rates equal a higher premium. Adding all that together gives the warrant premium.