A safer alternative to spread betting

Spread bets are a fast, effective and cheap way to trade. However, setting up a bet and then deciding on both the type of stop-loss order needed and the price level at which it should kick in can seem fiddly. There is an alternative that automatically builds in some downside protection the covered warrant. Anyone familiar with the traded options market will know all about these as the mechanics are very similar. For new investors, here's a guide to all the basics plus some of the key factors that influence the price.

What is a covered warrant?

The first covered warrants appeared over 20 years ago, so they are hardly new despite recent attempts to rebrand them as 'turbos'. Indeed, they are pretty common on many European exchanges and in the UK you can trade them easily enough via an online broker as they are listed at the London Stock Exchange (LSE). Here's how they work.

Let's say you want to place an up bet on a share price using a warrant. So you buy a six-month 'call' warrant on 1,000 shares (in open outcry trading pits, a buyer literally calls an asset over to buy it, or 'puts it away' to sell hence the 'call' and 'put' jargon for up bets and down bets.) The warrant strike price is £2.50 and the shares themselves trade in the open market at the LSE at £2.80. Your non-refundable premium per share is 50p, or £500 in total.

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What you now hold is the right to 1,000 shares at a fixed £2.50 each. That sounds great given that the market price is £2.80 why not demand 1,000 shares from the warrant writer (say SocGen) immediately and sell them on for a 30p per share profit? The answer is the premium of 50p. You actually need the share price to rise to at least £3 before you break even (£2.50 + 50p). Cash in the option now and you make a 30p per share profit, being the difference between the fixed £2.50 strike and the £2.80 share price. To that extent the option is 'in the money'. However, you are now down 20p once you knock off the premium (30p-50p). The further above £3 the share price rises, the further 'into the money' and true profit the warrant travels. In reality, though, you probably don't want the hassle of demanding 1,000 shares at £2.50 only to have to offload them at the market price. So you'll simply sell the warrant for its new higher premium value (see below).

And if the trade goes horribly wrong? The share price might plummet, in which case the right to buy at £2.50 is useless you'd be better off buying the shares on the open market. However, the good news is your losses are limited to the 50p premium per share no more and no less. That's reassuring, except that it is still a hefty 100% of your initial investment. However, unlike a spread bet, losses cannot exceed this amount.

How covered warrants are priced

The exact pricing mechanism is beyond the scope of this piece as it involves some complex (Nobel-prize winning!) mathematics. However, that's not needed to understand the key factors that influence what you pay as a premium.

First there's the so-called 'intrinsic value' of a warrant the gap between the strike and current share price. In the earlier example that was 30p. But that's not all. Since you have six months in which to exercise the warrant, you pay for 'time value' too. This is a function of several ingredients including: what interest rates and dividend yields will do (if you hold a warrant instead of shares you don't get dividends but you do save yourself some cash that can be invested); the expected volatility of the share over the next six months (the higher it is the more you pay for the warrant); and the duration of the warrant (naturally, like say an insurance policy, a six-month warrant is cheaper than a nine-month and so on).

As a rule of thumb, the more volatile the equity market (this is captured by the CBOE VIX indicator), the more expensive covered warrants will be. So the best bet is to try and anticipate increased volatility, rather than wait for it to happen before buying a warrant. Of course, this is easier to suggest than to do.

The jargon explained

The jargon involved in trading covered warrants can be confusing. And no more so than the difference between 'in' and 'out of the money' and 'break-even points'. An 'out of the money' warrant is usually very cheap on a call warrant the strike price is above the current share price, so you can get the shares cheaper in the open market than you can using the warrant.

Why buy one? Well, if the share price suddenly spikes, you'll make money. An 'in the money' warrant by contrast would have a strike price below the current share price. In theory that means you make money immediately, but don't forget that's only if the premium you paid was less than this gap. To get to the 'break-even point' for a covered warrant that is a call, you add the premium to the break-even point. Even then you may need to add on a bit for trading costs as premiums can be subject to a bid-to-offer spread