What You Can Invest In
Covered Warrants
Introduction
Given the flexibility of warrants and the fast-paced nature of the markets, it is important to understand different warrant investment strategies in order to achieve the desired risk/reward profile.
Speculation
One of the most attractive features of warrants is the leverage effect or gearing that they can offer. However, as the movement of the underlying security is one of the most important factors determining a warrant's price, it is imperative to first have a strong directional view on the movement of the underlying security. This can be based on fundamental research, technical analysis or a combination of the two.
Once the investor has established a view, he/she can either enter into a traditional long or short position or buy a warrant, which costs a fraction of the price of the underlying security. As such, warrants present the advantage of limiting the losses to the premium paid whilst still offering unlimited directional exposure (both bull and bear through calls and puts, respectively) to the underlying security.
However, investors should remember that the potential pay-off of put warrants is limited due to the fact that the value of the underlying security cannot fall below zero. The elasticity of a warrant, as discussed in the previous chapter, is a key element to examine when defining the desired risk/reward profile and subsequently choosing the appropriate warrant.
Example
Two habitual share traders feel that UK telecoms sector is due a rally and that at 105p, Vodafone has considerable upside potential. However, because of the huge increase in individual stock risk that has emerged over recent months, they decide to gain upside exposure via covered warrants rather than via the underlying share. However, they both have very different appetites for risk and hence for gearing.
Assume there are five SG call warrants to choose from to take a leveraged position on Vodafone. All of these calls have a conversion of 1:1 and are European style. Maturity in each case is 3 months.
| Exercise price | Warrant price | Delta | Effective Gearing | Theta |
|---|---|---|---|---|
| 90p | 16.50p | 0.78 | 4.96 | -0.02 |
| 100p | 10.25p | 0.61 | 6.25 | -0.04 |
| 110p | 5.75p | 0.42 | 7.67 | -0.04 |
| 120p | 3.00p | 0.26 | 9.1 | -0.03 |
| 130p | 1.50p | 0.15 | 10.5 | -0.02 |
The first of the investors is a conservative investor. He believes that the share will rise but he prefers to buy a warrant with some intrinsic value and with relatively low gearing. He therefore buys 20,000 of the 90p strike call warrants for 16.50p per warrant, giving a total outlay (before brokerage fees) of £3,300.
The second investor is more aggressive and believes that the rise in the shares will be rapid and significant. She decides to buy 20,000 of the 120p strike (out-of-the-money) call warrants for 3p per warrant, giving a total outlay of £600.
One week later, both investors have anticipated correctly the direction of the shares which now stand at 130p, a sharp rise of 23.8%. All other parameters, such as interest rates and volatility, remain stable.
Investor One
Following the rise in the share, the price of the warrant (as calculated by the delta) rises by 19.5p from 16.5 to 36p, a gain of 118%. This rise occurs over 5 days, which would have incurred a negligible negative time decay (theta), on the warrant of 0.1p.
Investor Two
In this case the price of the warrant (again calculated by the delta) rises by 6.5p from 3p to 9.5p, a gain of 217%. Again, with a theta of 0.03p per day, the time value erosion has little effects.
In the above example, two investors with different risk appetites obtain different results due to the leverage involved in the investment.
Hedging
A popular strategy involving warrants is the hedging of a portfolio, i.e. protecting the portfolio's value against a market correction. Put warrants can act as an insurance policy as they guarantee a minimum value for the underlying security. This is equal to the exercise price of the warrant. The price of the protection is equal to the premium paid.
Should the market fall, the value of the portfolio will decrease. However, this loss can be either partially or fully offset by the appreciation of the put warrants. Contrary to hedging with exchange-traded index futures, where the potential loss on the hedge is unlimited should the investor be mistaken about the direction of the market, the maximum loss on put warrants is limited to the premium paid.
Hedging Step by Step
(a) Select the Exercise Price
The choice of the exercise price corresponds to the minimum value that investors would like to guarantee for their portfolio. Using put warrants over the index, investors should be able to obtain a reasonably good hedge by choosing the exercise price that corresponds to the market level at which they wish to protect the value of their holdings.
(b) Determine the Beta of the Portfolio
The hedge will be more accurate the higher the correlation between the actual portfolio and the underlying security of the put warrant (e.g. the FTSE 100 Index) This can be measured by looking at the historical correlation and the beta of the portfolio, which is the measure of an equity portfolio against its benchmark.
A beta of 1.0 indicates that a portfolio or a share will move in line with the index against which it is being ensured. A beta of 1.2 means that if an index increases or decreases by 10% then the portfolio or share will increase or decrease by 12%. So, a beta above 1 is riskier than a beta below 1.
Clearly, the more diversified an investor's UK portfolio of stocks is, the more likely it is to be closely correlated to the FTSE 100 Index. An investor holding just a handful of shares would be better advised to look at hedging those shares on an individual basis. For the purpose of the following example, we will assume a portfolio with a beta of one.
(c) Calculate the number of warrants to buy
The number of warrants necessary is calculated as follows:
Example
An investor holds a £100,000 well diversified portfolio of UK shares which he is keen to protect against any further prolonged downturn in the market. Rather than sell the shares, which could trigger a capital gains event (he has held some of these shares for many years) he decides to buy put warrants. With the FTSE 100 Index at 5000, he decides to buy protection at 4750 over a period of 3 months.
| Exercise price | 4750 (out-of-the-money) |
|---|---|
| Expiry | 3 months |
| Delta | -0.31p |
| Price | 27.5p |
Conversion ratio : 500:1 (500 warrants represents 1 unit of FTSE 100 Index)
The number of warrants to buy is calculated as follows:
This means that the investor should invest £2,887.50 (before brokerage) to protect his £100,000 portfolio at expiry in 3 months time. This effectively means he is paying an insurance premium of 2.9% for protection at 4750.
Cash extraction
Another interesting strategy involving warrants enables investors to extract cash from a portfolio or an individual whilst maintaining an equivalent level of exposure to the underlying. This is a conservative strategy which is often used where an investor wants to protect profits but retain upside potential. An extreme example is used here to illustrate the point:
In September 2000, an investor with a holding of 10,000 Marconi shares is sitting on a very substantial profit as the stock touches £12. However, he is worried that if he sells the shares he may miss out on further upside potential, having read press comments about a possible move to £16. So, he decides to sell his stock but maintain exposure by replacing it with a call warrant.
| Exercise price | 1300p |
| Expiry | 6 months |
| Share price | 1200p |
| Warrant price | 17p |
| Conversion ratio | 5:1 |
Via his broker, the investor sells his shares at 1200p and buys 50,000 SG 1300 call warrants for 17p. By doing this he releases £111,500 from his investment but retains upside exposure.
6 months later Marconi has fallen from 1200p to 380p. Clearly the 1250p call warrant expires worthless and the investor has lost £8,500 of warrant premium from that side of the trade. But he is far better off than if he had simply maintained his position in the shares. In this case he would have lost £82,000.
