Guide to Covered Warrants

Covered Warrants enable you to take a view on either a rise or a fall in a wide-range of assets such as shares, indices or commodities. They are listed on the London Stock Exchange, so they are highly regulated and easily accessible during trading hours.

Unlike investing in shares, an investment in Covered Warrants will have a fixed life with an expiry date typically set three, six or twelve months in the future. They are purchased for a premium, which is represented by the ‘ask price’.

Low trading amounts enable investors to access the markets with potentially limited capital at risk. In theory an investor could buy just one Covered Warrant at a price of as little as 20 pence plus the broker fee.

There are two types of Covered Warrant:

• A Call Covered Warrant and
• A Put Covered Warrant

Call Covered Warrants

Call Covered Warrants enable you to benefit from a rising market. On expiry, the Call Warrant will generate a cash payout if the asset price has risen above a fixed level called the strike price.

Put Covered Warrants

Put Covered Warrants however may generate a cash payout on expiry if the asset price has fallen below the Strike Price. These can be used for both investment purposes and to protect a portfolio from falling prices.

On expiry, a Covered Warrant automatically deposits any funds owed to your share dealing account. Covered Warrants may also be sold prior to their expiry using the ‘bid price’. At any point during a trading day you can trade in or out of a position and take any profit or realise losses.

Covered Warrants have a fixed expiry date - usually six or twelve months from the issue date. At expiry, a warrant will pay out depending on how far a particular share, index or commodity is above a fixed level known as the "Strike" price which is set on issue.

The higher the share price is above the strike level, the higher the potential payout for a Call warrant. If the share price is below the Strike price, the warrant expires with no payout. For a Put Warrant to generate profit, the share price must be below the stated Strike price.

As all Covered Warrants are listed on the London Stock Exchange and traded through a Share Dealing Account, executing your strategy is easy.

Each product has a London Stock Exchange code starting with an ‘R’ for example “R036”. Through a Share Dealing Account you can gain quotes and conduct market transactions in the same way as buying and selling shares.

When you have purchased your warrant it is important to monitor it’s performance to determine the best course of action.

With a Covered Warrant you could:

Exercise - if a warrant is performing well at any point in the investment term, you may wish to exercise your right to buy or sell the underlying asset. If no action is taken and the warrant is showing a profit on expiry, it will automatically exercise and the funds will be credited to you. If a warrant has made a loss on expiry your initial capital is lost.

Close out – you can close out your warrant position by selling it back to the market, capitalising on both time and intrinsic value. Your profit is determined by any potential difference between the purchase price and the sale.

Abandonment – If your intuition was wrong and your warrant is worthless on expiry, you can abandon your position and it will be automatically closed

Stamp duty

As Warrants are generally cash-settled, upon exercise of the warrant, cash changes hands but no shares. Therefore there is no stamp duty to pay.

Income tax

Holders of stock warrants have no entitlement to receive dividends from the underlying and as there is no income, there is no income tax levied on warrants.

Capital gains tax

Warrants are treated the same as shares. Tax laws can, of course, change.

There are two fundamental reasons why Covered Warrants could be considered a good tool for investing defensively in uncertain markets:

• Limited losses and
• Gearing

Limited losses

Covered Warrants have the ability to provide uncapped gains if markets move in your favour, but your losses are limited to the amount that you invested. This means that you can invest in confidence, knowing exactly what you could stand to lose.

Gearing

Covered Warrants may allow you to benefit from the effect of gearing. Gearing is nearly always considered an advantage for investors looking to obtain a much larger exposure for their money, thereby multiplying their prospective profit or loss. However, it can also be used for more conservative investments where you chose to ‘gear down’ and take an equivalent position at a lower cost, thereby reducing your capital at risk in comparison to buying the share, index or commodity.

• Gearing: The ability to make higher returns from a positive move in the markets. But remember that gearing can also magnify your losses.
• Limited risk: You can not lose more than your initial investment
• Flexibility: The opportunity to profit from both rising and falling markets
• Simplicity: Warrants are traded in the same way as shares via a broker
• Diversification: Access a wide range of assets, including equities, commodities, indices, foreign exchange and interest rates
• Low entry: Very small minimum trading size
• Assurance: Highly regulated and liquid market provided by the London Stock Exchange
• Tax efficiency: Covered Warrants which are cash settled should not be subject to stamp duty but please contact your own tax advisor for details of how Covered Warrants will affect your tax situation.
• No exchange rate risk: Selected Covered Warrants use a Quanto feature to fix the exchange rate on non-GBP denominated underlyings.

The value of your investments may fall as well as rise.

Covered Warrants are leveraged products that carry a high degree of risk and it is possible to lose your entire investment.

These products may not be suitable for all investors, you should therefore ensure you fully understand the risks involved, and seek independent advice where necessary.

It is important to know that even though the amount you can lose is limited to the initial investment, gearing can magnify losses as well as potential returns. Also, because Covered Warrant contracts expire, you need to be aware that the time until expiry affects the price.

Like options, the value of a Covered Warrant prior to expiry is made up of two components. The first is the intrinsic value which is the amount by which the underlying asset exceeds the Strike Price of the Covered Warrant. The second is Time Value which refers to the amount by which the current price of the Covered Warrant exceeds the Intrinsic Value. The Time Value represents the price paid for the possibility of how deeply the warrant will finish in-the-money. As the Covered Warrant nears expiry the likelihood of ending in profit reduces and therefore the Time Value reduces.

In addition, you also need to be aware that if your expectation for a particular price move on an asset comes to fruition after the Covered Warrant has expired, you will not profit from that price move because the Covered Warrant contract is no longer valid.

Covered Warrants on Emerging Markets

Investing in emerging markets involves certain risks and special considerations not typically associated with investing in other more established economies or securities markets. Investors should ensure that they understand the nature of all these risks before making a decision to invest.

Corporate actions

The Important fact to note is that the Strike Price and Payout Multiplier of a Covered Warrant may change over the course of the term due to the company issuing more shares, for example, in the case of single stocks or indices. Should this happen, you are not required to do anything. You will retain the same number of Covered Warrants, with the same economic exposure to the underlying.

Dividends

Covered Warrants may effectively discount the value of an anticipated dividend to maintain constant pricing when a stock trades ex-dividend. The holder of the Covered Warrant will not receive a dividend payment.

Covered Warrants can be used to protect a portfolio against falling markets. If an investor owns a portfolio of UK stocks and believes prices have a negative out-look in the short-term, but does not want to sell them, a Put Warrant on the FTSE 100 could provide a good alternative.

As the FTSE 100 falls, the increasing value of the investors’ Put Warrant will compensate some or all of the loss from the reduction in value of the shares. In this way, Put Covered Warrants can help to protect a portfolio against adverse market falls.

If concerns are unfounded and the markets rise, the investor will continue to benefit from the increase in share price and the Put Covered Warrant will expire worthless. The capital invested in the Put Warrant will be lost in this instance.

A well diversified portfolio is advisable in times of market uncertainty. Covered Warrants are available on a large number of UK and US equities, domestic and international indices as well as commodities.

Covered Warrants open up markets that would be expensive or impossible to access through direct investment. Investors can benefit from a vast range of themes such as Emerging Markets and Alternative Energy. Commodities such as gold, silver and oil provide alternatives outside that of traditional shares or indices.

Covered Warrants are flexible investment tools that trade, just like shares, on the London Stock Exchange. They give investors the right but not the obligation to buy or sell an underlying asset, at a specified price, on or before a set date.

The geared nature of covered warrants means that a relatively small movement in the share price of the underlying asset will result in larger movements in the value of the warrant.

Therefore, covered warrants provide the opportunity for greater returns than ordinary share dealing but also greater risks and potential losses.

You cannot lose more than your initial investment, however with Covered Warrants you do not qualify for dividends as you don’t actually own the share.

Before investing in a Covered Warrant you should fully understand how they work and the risks involved. If you are in any doubt you should consult an Independent Financial Advisor.

Find out more about Covered Warrants by visiting the Learning & Research pages on natweststockbrokers.com