December 2005 - January 2006
Want to add some sparkle to your portfolio? Introducing: Warrants...
any information nor any opinion contained in this paper constitutes
an offer to buy or sell or a solicitation by or on behalf of Berkeley
Capital and/or any of its affiliates (together “BCR Group”)
of an offer to buy or sell any security, product, service or investment.
Any opinions expressed in this article do not constitute investment
advice and independent advice should be sought where appropriate.
Investors looking to take on more risk in exchange for the potential
for greater returns might seem like rare beasts in this day and age,
but the growth in the warrants sector in recent years indicates that
this is not the case.
can be an attractive area for both investment and speculation but there
is a widespread lack of understanding as to how they actually work.
Traditional warrants can be issued by a variety of companies but historically
the market has been dominated by the investment trust sector.
Covered warrants were made available to UK private investors for the
first time when they were introduced on the London Stock Exchange in
October 2002. These versatile instruments, which have already proved
popular in other countries, offer a variety of investment solutions for
a range of investors.
of the questions many investors ask is where the name comes from – why
are they called covered warrants? The term ‘covered’ denotes
the fact that when the issuer sells a warrant to an investor, they
will often ‘cover’
(hedge) their exposure by buying the underlying stock in the market,
or by using other instruments. Covered warrants have on average a life
of six to twelve months, although some have a longer (or occasionally
They can be bought and sold at any time during their lives.
is a covered warrant?
warrants are issued by financial institutions and then listed as fully
tradable securities on the London Stock Exchange. A covered warrant gives
the holder the right (but with no obligation) to buy or sell an underlying
asset, at a specified price, on or before a predetermined date.
For many investors, covered warrants will seem similar to options.
Covered warrants typically have longer maturities than options, and
are issued over a wider range of assets. The terms are also more varied – covered
warrants are highly flexible and can be issued with terms structured
to meet market demand. For example, in the same market segment as covered
warrants are certificates, which are ungeared and provide a lower risk
exposure. With covered warrants you cannot lose more than your initial
investment. Your maximum loss is known in advance, and there are no
margin calls, i.e. further payments to maintain your position. This
differentiates covered warrants from some other forms of derivatives.
Types of covered warrants
Covered warrants on single stocks account for a little over half
of those available. The main focus is on popular UK
‘blue-chip’ shares such as BP, GlaxoSmithKline, Lloyds
TSB, Royal Bank of Scotland, and Vodafone, where there are numerous
competing warrants from different issuers. There are also some
covered warrants on popular shares in other markets, including
US stocks such as Microsoft and Yahoo.
For exposure to a particular theme or sector, a number of securities
are sometimes grouped together in a ‘basket’. Investors
can then obtain exposure to this basket simply and efficiently
by buying one single security in the form of a covered warrant.
In most covered warrants markets around the world, the most actively
traded warrants tend to be those on the main domestic market index.
In the UK, the FTSE 100 Index has been a consistently popular underlying.
Covered warrants have also been issued over other UK market indices
such as the FTSE 250 Index, and a range of overseas indices. Investors
wishing to gain exposure to the Dow Jones Industrial Average, Nasdaq
100 Index, Nikkei 225 Index, Hang Seng Index, DAX Index, CAC 40
Index, and others can do so using UK covered warrants. There are
also warrants that give exposure to house prices via the Halifax
house price indices. You can gain exposure to the wider UK house
prices and profit from the increases and decreases.
It can be difficult for private investors to gain exposure in sterling
to major commodities such as gold, silver and oil. Using covered
warrants it is possible for investors to take positions on these
commodities, in small size and in sterling.
The same applies to currencies. Covered warrants are available
on a range of exchange rates, including sterling/dollar, sterling/euro
Gold warrants allow investors to gain leveraged exposure to movements
in the price of gold – either on the upside with call warrants,
or on the downside with put warrants. The warrants are priced in pence,
with no minimum trade size. The price of gold is influenced by supply
and demand expectations. Gold supply comes from mine production figures
(typically around 2,500 tonnes a year) plus gold recycled from scrap.
Demand for gold is driven by fabrication of gold jewellery, coins and
bars for investment purposes.
tracker certificates, a warrant has a fixed expiry date. Upon expiry,
any positive value in the warrant will automatically be paid out to
the warrant holder. The payout formula for a gold call warrant is as
per warrant = [price of gold at expiry – warrant exercise
parity for the gold warrant is 100. Investors should note that the
formula above gives a dollar amount, which is automatically converted
into sterling by using the GBP/USD exchange rate at expiry.
example, consider the price of a $400 gold call warrant if, at expiry,
gold was trading at $450 and the GBP/USD exchange rate was 1.90. In
this case the price per warrant at expiry would be ($450-$400)/100
= $0.50. Converting this into Pounds, with an exchange rate of 1.90,
gives a payout amount of 26.3p per warrant. Had the price of gold been
below $400 at expiry, the warrant would have expired worthless. For
a put warrant, the payout amount is determined by how far the price
of gold lies below the warrant exercise price at maturity. For example,
the holder of a $400 gold put warrant would be paid 26.3p if the price
of gold was $350 at expiry (and the GBP/USD rate was also 1.90).
there is no need to hold a warrant to expiry as the price of a gold
warrant moves with the price of gold on a second by second basis. This
allows profits to be taken following a favourable move in gold (or
losses cut following an unfavourable move) at any time. As gold warrants
offer leveraged exposure to the price of gold, they are riskier investments
than a corresponding investment in an unleveraged tracker certificate.
If you are correct in your investment view, the rewards, of course,
should be higher. Other market factors such as the level of interest
rates and market volatility can also influence the price of the warrant.
to start using covered warrants
investing in warrants investors should first consider the following
What am I trying to achieve?
• How much risk/leverage am I prepared to accept?
• What is my time frame?
• How much can I afford to lose?
investors have answers to these questions they can begin to look at
the range of available warrants to find which one best fits their requirements.
One of the most attractive elements of the covered warrants market
is that you can buy and sell these instruments as easily as you would
trade ordinary shares. The costs of dealing in covered warrants are
relatively low, similar to those of an execution-only dealing service.
Indeed, most brokers will deal in covered warrants for the same price
as they deal in ordinary shares.
Trading covered warrants
You trade warrants through a stockbroker and not with an issuer.
You can choose between advisory and execution-only brokers, as well
as between brokers that offer internet/telephone and telephone-only
services. The trading day runs from 8.15am until 4.30pm. All covered
warrants are CREST-settled in T+3 like equities. There is no need
to set up a separate, dedicated account, as you have to do for spread
betting. Unlike equities, warrants are not subject to stamp duty.
To ensure that you can track the market effectively there are a number
of online services available from the London Stock Exchange, the
major issuers and a number of information service providers. Newspapers
and popular investment magazines also publish the prices of warrants
on a regular basis – see ‘Places to go for more information’.
Exercising covered warrants
UK covered warrants are cash-settled instruments. This means
that the issuer will pay a cash amount for the intrinsic value
of the warrants at the expiry date, or on exercise, if sooner.
In other words, although the terms of Call warrants are usually
expressed as a right to buy, and Put warrants as a right to sell,
they are more accurately a right to receive a cash payment equivalent
to the difference between the exercise or strike price and the
value of the underlying asset at expiry.
Before you trade, you should be satisfied that warrants are
suitable for you in the light of your circumstances and financial
position. If you are in any doubt you should consult an appropriately
qualified financial advisor. The following summary cannot
disclose all the risks and other significant aspects of warrants.
Warrants are not suitable for all investors. They can
be volatile investments and may expire worthless. You
should not deal in warrants unless you understand their
nature and the extent of your exposure to risk. You should
not buy a warrant unless you are prepared to lose all
of the money you have invested plus any commission or
transaction charges incurred.
Warrant investors should be aware that, if the underlying
instrument to the warrant moves in the opposite direction
to that anticipated by investors, the losses incurred
by the warrant may be greater in percentage terms
than those incurred by the underlying itself.
Warrants have a limited life, as denoted by the
expiry date of each issue. After this date, warrants
can no longer be traded. It is therefore important
that the forecast move in the underlying instrument
of the warrant take place during the life of
the warrant. It must also be noted that warrants
experience time decay (erosion of their time
value) throughout their life, and that the rate
of this decay accelerates as warrants near expiry.
The foreign exchange rate will affect the
price of a warrant over a commodity as it
is determined in the local currency of the
underlying and then converted into sterling.
General market risks
In addition to movements in the underlying
security, factors such as movement in interest
rates, currencies and implied volatility
have an impact on the price of warrants.
Careful groundwork will bring long-term
rewards. The usual investment disciplines
apply. Set clear goals and objectives,
particularly prices at which to lock
in profits and cut losses. Following
them will be important in ensuring that
warrants prove a successful instrument
for enhancing and protecting your investment
returns. For a better understanding of
covered warrants, please refer to Covered
Warrants – a Detailed Guide. This
guide explores warrant dynamics as well
as examining trading strategies in more
depth and applications for the investor.
participants in the covered warrants
market stress the need for education
to help investors understand covered
warrants and use them successfully.
There are a number of websites which
offer comprehensive background information
dealing with what covered warrants
are and how they work, alongside more
specific price information and technical
• The McHattie Group – www.coveredwarrants.co.uk or www.mchattie.co.uk
• The main current issuers – DrKW,
Goldman Sachs, JP Morgan, SG and
More Business Forum
More articles by Jateen Patel, Director, Berkeley Capital
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