Spread betters can take advantage of price swings and use stop-losses to limit potential damage. But there's an alternative that comes with a built-in safety mechanism the covered warrant.
Volatility has been lying low. The Chicago Board of Trade's VIX index a favoured measure of volatility for equities, based on S&P 500 option prices has hovered around 17 having hit multiples of that during the worst of the credit crunch. But this calm may not last. Central banks have yet to work out how to withdraw huge stimulus packages. China's rapid growth is showing signs of stalling.
Spread betters can take advantage of price swings and use stop-losses to limit potential damage. But there's an alternative that comes with a built-in safety mechanism the covered warrant.
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How they work
Covered warrants (or 'Turbos') are very similar to options. And they've been around a pretty long time. Socit Gnrale listed its first covered warrant, on Alcatel shares, more than 20 years ago. Indeed, in Europe they are a common product on many exchanges, which is why some investors like them. In the UK, for example, you can buy and sell many warrants easily at the London Stock Exchange (LSE) via your existing online dealing account.
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For example, say you want to bet on a share price rising. You buy a six-month 'call' covered warrant on 1,000 shares. It has a strike price of £2.50 and you pay an upfront premium of 50p per share. The actual shares trade at £2.80 each on the LSE. The call warrant gives you the right to buy 1,000 shares at the fixed strike of £2.50 anytime in the next six months. Of course, you've paid a non-refundable premium of 50p per share. So you need the share price to hit £3.00 (£2.50 + 50p) just to break even (ignoring dealing costs).
So, if the share price hits £3.50, you could exercise the warrant and 'call in' a profit of £1 (£3.50 less the strike of £2.50) minus the premium of 50p. That's 50p per share or £500 in total. You could have placed an upbet on the share using a spread bet. But the attraction of a warrant is it automatically limits your downside to 50p per share, no matter what.
The other type of covered warrant you can buy is a 'put'. This gives you a similar ability to profit from falling share prices. It's worth noting that under current regulations, retail investors can only buy, or 'hold' covered warrants, and not sell or 'write' them. The 'cover' comes from the fact that the bank that creates the warrant Societe Generale, or perhaps Barclays stands ready at any time to either deliver the shares you demand (in the case of a 'call') or to take delivery and hand over cash (in the case of a 'put'). Of course, you don't have to exercise a warrant, indeed many are 'cash settled'. That simply means you either choose to sell the warrant back if the premium rises and take a profit, or when the warrant expires you settle up any profit or loss in pure cash. That way no shares need to change hands.
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How does the premium work?
In the earlier example you may have noticed something odd. The gap between the strike price of £2.50 and the current share price of £2.80 was 30p. Yet the warrant cost 50p. But given that the profit from exercising it at that point is only 30p, why pay more than that? The answer lies in the fact it is a six-month warrant. Sure, exercise it right away and you'll lose money. Your 30p profit is dwarfed by the 50p premium.
But over the next six months you hope the underlying share price will rise sharply. The longer the warrant runs the more you will pay for this 'time value'. It's a bit like buying insurance a year's cover costs more than six months. So in crude terms you could say that the premium is made up of 30p of 'intrinsic value' (the minimum charge for the warrant to stop you exercising it for a profit straight away) and 20p of 'time value'. Supply and demand plays a role too. If a warrant is illiquid and tough to trade you'll pay a premium simply for its rarity value. Unless you're an expert, steer clear of these and stick to popular exchange-traded warrants.
Finally, a word about traded options. These are similar to covered warrants in many respects but are more suited to professional investors. You will need a special trading account. But once registered with a broker, you can write and hold options (in effect that means you can opt to play the role of the casino not just the punter). You will often find that the price of an option the premium is lower than the equivalent covered warrant. But before diving in, also check the bid-to-offer spread. Here you may find a covered warrant is more competitive.
