Should you try covered warrants?

Many investors get their first taste for derivatives through spread bets. These mimic a contract used very widely in financial markets the forward, or future. This tends to be traded on big exchanges and requires large minimum commitments from investors as the contracts are designed for use by investment banks and other city institutions.

Spread bets and CFDs (contracts for difference) are the retail equivalent, with CFDs being closest in terms of the tax treatment. The advantage of both is that they allow you to place much smaller bets.

However, sooner or later, most investors come across a rather different beast the retail covered warrant (branded as the 'turbo' in the case of Soc Gen's offering). These are similar to another product widely used by the professionals the option.

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So should you make the switch?

In short, a covered warrant's biggest major upside is built-in limited risk. However, it has a serious downside complexity.

Here's roughly how a covered warrant works. They come in two varieties the call and the put (in open pit trading you will sometimes see a trader literally 'call' an asset across the floor, indicating that they want to buy. 'Putting it away', on the other hand, suggests they are selling hence the jargon).

So a call warrant might give you the right to buy shares in a company at a fixed 'strike' price of, say, £2.50 when the underlying share is trading at £2.20. The warrant expires in nine months (so you have nine months to either use it or lose the premium). You pay a small non-refundable up front premium of, say, 20p per share.

This warrant is 'out of the money'. That's because at the moment you'd be better off buying the shares in the open market for £2.20. An 'in-the-money' warrant would be pricier. So how do you make money?

Buying a call warrant is bullish if the share price rockets up from £2.20 (remember there are nine months to go before it expires) the warrant will increase in value too. Let's say it climbs to 30p per share you could sell the warrant and take away a profit of 10p per share (ignoring commission and spreads) without ever buying the underlying shares. Better still, fans argue, the downside risk is limited to the 20p you paid should the underlying share fall. No need to set stop losses the upfront premium is your worse case loss. Fine but remember that's still a chunky 100% loss in terms of what you invested.

Put warrants are a similar way to bet on falling prices, again with limited risk built-in. So what's not to like?

Well, pricing covered warrants is complex and beyond the scope of this article. But suffice it to say that the premium includes a charge for future volatility - in short when volatility is low they are cheap and when it is high (the CBOE Vix index gives a rough indication) they tend to be expensive. But working out whether you are getting a bargain or not isn't easy.

That issue aside, although popular in mainland Europe for UK investors, spread bets and CFDs are the more common offering through most brokers and tend to offer the widest range of bets. The sheer number of brokers in the space also keeps spreads pretty tight, particularly on popular (eg FTSE 100) bets. So as a novice I'd stick to spread bets.