A Short Guide on Covered Warrants

Summary:

Covered warrants offer traders the right, but not the obligation, to buy or sell an underlying asset. This article explores the types of covered warrants and their functionality. We strongly recommend reviewing the warrant's prospectus to grasp the terms and conditions before investing. It's essential to be aware that you might encounter experienced traders with extensive knowledge of underlying assets. Therefore, a thorough understanding can facilitate more informed and effective trading decisions.

Covered warrants provide the right (not obligation) to buy or sell an underlying asset before/at a predetermined date. In this case, the issuer is typically a financial institution. The predetermined price is known as the strike price. Case in point, there are two types of covered warrants, namely put warrants and call warrants.

What are covered warrants?

A warrant is a kind of investment security. Covered warrants are listed on international exchanges like the London Stock Exchange. They are also listed on other stock exchanges such as that of Singapore, and Hong Kong. 

The warrant is typically said to be covered as the financial institution, which is an issuer, sells a warrant to an investor and it covers the exposure by purchasing the underlying asset in the market. Some investors might confuse it with options. In this case, you must know that covered warrants have longer maturities, and they are generally issued over a wide array of assets. Covered warrants are more feasible than options and can be issued with terms customized to meet the evolving market and its needs. When you are availing of covered warrants, the maximum amount you might lose is your initial investment. There are no margin calls, i.e., you do not have to pay any extra to control your position. Unlike options, covered warrants can be purchased instead of written. While options can expire within a week to two years, a covered warrant comes with a lifespan of six to nine months.

An investor who is selling a call option while writing one means that they must deliver shares at a predetermined price on a particular date to the buyer if the buyer exercises the call. Now if one writes a put, they have to sell the put option, which means that the seller is obligated to purchase shares if the buyer of the put exercises the right to sell at a set strike price. However, one similarity is that covered warrants are composed of intrinsic value and time value, just like options.

Here are some other things to keep in mind about covered warrants:

• A covered warrant can be of European or American style. 
• If it is of the European style, then it indicates the exercise of right can only happen on the expiration date. 
• On the other hand, if it is of the American style, the investor can carry on with his right at any point between the purchase and expiration dates.

Types of covered warrants

Covered warrants can include single stocks, indices, currencies, or commodities as their underlying assets.

• Stock warrants: Covered warrants on single stocks mean a significant number of those available. Several stocks are generally grouped and categorized together to fit a particular sector or theme. Investors can access these grouped stocks easily by just purchasing one single security, which is a covered warrant.
• Index: In the majority of covered warrant markets, the instruments that see the highest trading activity are typically those linked to the primary domestic market index. This trend reflects the strong investor interest in the performance and movements of their home country’s core market index.
• Commodity: It can be quite challenging for investors to gain exposure to main commodities. Investors, with the help of covered warrants, can take positions on commodities in small portions and in sterling. The same is also applicable in case of currencies.

How does a covered warrant work?

• Issuer: These are issued by banks or investment firms that want to create and sell the warrants. 
• Underlying asset: Every covered warrant is typically related to a certain underlying asset, which we have mentioned in the article.
• Expiration date: They come with a specific lifespan, which can range from a few months to two years. 
• Trading: They are generally traded on organized exchanges and the price is dependent on time to expiration and interest rates, to name a few. 
• Settlement: When a covered warrant is exercised, the hold has both options, that is to buy or sell the underlying asset at the predetermined strike price. 
• Leverage: These come with the potential for leverage as investors can be exposed to the underlying asset's price movement without having to invest the total amount needed to purchase the asset.
• Risk: These are highly sensitive and can change due to the underlying asset's price and market conditions. Investors must research well and find out the related risks before jumping in. 

Example

A classic example of using covered warrants is known as stock replacement, also known as cash extraction. Suppose the FTSE 100 Index has improved over the last year; a portfolio manager wants to see if the market advances more but then again, he is worried about a market decline. What is the solution here? Well, a strategy must enable him to sell the shares and invest some cash in FTSE 100 call warrants. If the market grows further, then holding the warrants will allow the individual to book gains but with a lower amount of capital than holding the underlying shares of the FTSE 100. However, if the market does not show growth, the premium paid for the warrants will be lost.

To conclude, covered warrants come with its own share of risks. Read the offering documents to gain deeper insights into the underlying asset and the market conditions which can influence the covered warrant's value.