Coveredwarrantsguidevincestanzione

8/14/2019 Coveredwarrantsguidevincestanzione

1/12

Harness the power ofgeared investment

April 2009

Your guide to investmentskills& techniques

04 10 1307 12In associationwith

Welcometo warrant

world

What is awarrantworth?

Control yourriskswithwarrants

Trade theworld insterling

Super-chargedprofits

COVEREDWARRANTS


2/12

APR APR INVESTORS CHRONICLE

MASTERCLASS COVERED WARRANTS

WARRANTWORLDCovered warrants are one of the best

ways to turn your views into cash

JARGONBUSTING Our guide to commonly used covered

warrant terminology

TRADE INPOUNDS A variety of covered warrants allow

you to forget about currency issues

HOWTOPRICE We show how warrant pricing is

logical and straightforward

SUPERCHARGED Leverage is how you turn modest

moves into massive profits

CONTROLRISKS Protect your portfolio

WHYWARRANTS? We compare rival derivatives

If you fancy making big returns from small price changes, butdont like the

idea of open-ended risks, its time you considered covered warrants. Although

less well-known than spread-betting, contracts for difference (CFDs) and

futures, these clever instrumentsgive you many of the same advantages but

without someof the uncertainty.To findout what covered warrants are and how they work,Welcome to War-

rants World on pages 4-5 will putyou right. We then compare them with other

leveraged products in Whywarrants? on page 14. Covered warrant jargon can

be a bit dauntingto the newcomer, so check outour simple guide on page 6.

Themain attraction of covered warrants is their ability to amplify returns,as

weshow on page12. But theycan alsobe usedto reduceyour overall risks and

protectyour wealth see page 13.

Covered warrant pricing takes a bit of learning, butits nothing too taxing. If

you dontknow your intrinsic value from your time value,allow us to enlighten

you, on pages 10-11. We also explore how warrantscan let you trade different

assets around the world without ever switching currencies.

Dominic Picarda, CFA

Masterclass editor

Editorialtel: 0207775 6582E-mail use: firstname.surname@ft.comwww.investorschronicle.co.ukInvestorsChronicleThe FinancialTimesBusiness LtdOneSouthwark BridgeLondonSE1 9HL

Masterclass Editor:DominicPicarda Editor: Oliver RalphDeputy Editor:Rosie Carr Contributors:AlgyHall, JohnHughman,Simon Thompson Head of Design: EricaMorgan Senior Designer:Shannon Gibson Illustrator:

AndyMartin Production Editor:AndrewAdamson DeputyProduction Editor:David Braid SeniorSub-Editor:KateDisney Sub-Editor: SameeraHai Baig AdvertisingManager:

BethGordon-Smith 02077756601 DisplaySales Executive:JonathanHaselden 02077756600 OnlineSalesManager:Brian Cross020 7775 6598 Sponsorship Sales Manager:RobertReed020 7775 6593 Head of Production:DeniseMacklin Deputy Head of Production:TeresaKirkpatrick 02077756556 PublishingDirector:JonathanChurch

Manyof thecharts inthe magazineare basedon materialsuppliedby ThomsonDatastream. The FinancialTimes Limited 2009.InvestorsChronicleis atrademarkof The FinancialTimes Limited. FinancialTimesand FTareregisteredtrademarksand service marksof The FinancialTimes Limited.Allrightsreserved.No partof thispublicationor informationcontainedwithinitmaybe commerciallyexploited in anyway without priorpermission in writingfromthe editor. Registeredoffice: NumberOne, SouthwarkBridge, London SE19HL.ISSN0261-3115 Material (includingtips) contained inthis magazine isforgeneralinformationonlyand isnotintendedto berelieduponbyindividualreaders inmaking (orrefrainingfrom making) anyspecificinvestmentdecision.

Appropriateindependent advice shouldbe obtained beforemakingany suchdecisions.The FinancialTimes Limited doesnot acceptany liabilityfor anylosssuffered byanyreader asa resultof anysuch decision.

Covered warrant pricingtakes a bit of learning,but its nothing too taxing

The mainattraction of

covered warrantsis their ability toamplify returns


3/12

4 MASTERCLASS 9 APR - 16 APR 2009

WELCOME TOWARRANTWORLDBy AlgyHall

Covered warrants are one of the most eective ways to turn

your views on the markets into cash. And theyre as good forprotecting your wealth as they are for building it


Suppose you have a hunch that a certain share

is going to rally strongly over the next few

months. To exploit this, you could go out

and buy the actual share, lets say for 1. The

share then goes up to 1.20 over the next few months

and youve made a 20 per cent return.

Alternatively, you could buy a one-year covered war-

rant on that share. Instead of having to invest the full 1,you only have to put up 30p. The rest of the money you

can invest elsewhere or keep in the bank to earn interest.

Every time the share goes up 1 per cent, this war-

rant rises 3 per cent. So, if the actual share goes up 20

per cent during the year, you make a 60 per cent gain.

Welcome to the wonderful world of warrants.

SmAll mOVES, big pROfiTS

This simplified example shows why more and more

traders and investors are turning to covered warrants

in order to profit from financial markets. These clever

instruments are ideal for making serious money out of

relatively minor movements in a whole range of assets.The ability to turn a small change in a price into a

much bigger profit is known as gearing. Covered war-

rants are specially designed to exaggerate the effect of

the assets they are linked to.

EASy TO uNDERSTAND

Covered warrants are a derivative product. This

means they are derived from other assets, such

as individual shares, indices, commodities, cur-

rencies or even baskets of shares. You can buy

either call or put warrants on these underly-

ing assets.A call warrant gives its owner the right to

buy the underlying asset at an agreed strike

price on that warrants expiry date, and is a way

of betting that the underlying asset will go up in

price. The put warrant gives the holder the right

sell at the strike price on the expiry date, and is a

bet that the underlying asset will fall in price.

limiT lOSSES AND TAkE pROfiTS

Importantly, even when a trade goes wrong the most

that you can lose is your original investment. This is

different to other derivative products such as contracts

for difference (CFDs) and spread bets where losses arepotentially limitless.

I really like covered warrants risk profile because

you cant lose more than you put in, says Ben Board,

head of UK listed products at Royal Bank of Scotland

I really like

covered warrantsrisk profile becausyou cant lose mor

than you put in


4/12

9 APR - 16APR 2009MASTERCLASS 5


(RBS). You know what youve invested and you dont

have to pay extra to keep a losing position open.

There is no need to wait for a warrants expiry date

to take profits or realise losses, though. Covered war-

rants are listed on the London Stock Exchange (LSE)

and can be traded through most stockbrokers at a

typical cost of about 10 a trade. Prices are provided

throughout the trading day and RBS, as a provider of

covered warrants, will settle deals from 8am when the

LSE opens until 7pm in the evening, although some

brokers might not take orders this late.

The fact that they are listed by the LSE mean

theyre regulated by the LSE, says Mr Board. And

that gives investors additional security.

mORE bENEfiTS

When you buy individual shares, you have to pay

stamp duty. Not so when you buy a warrant based on

those shares. This makes them good for traders who

like to nip in and out of markets quite frequently.

As with most investment products, any profits you

make may be subject to capital gains tax at 18 per

cent, depending on your circumstances. For this rea-

son, some traders may be tempted to use spread bets

to play the markets, as profits from these are tax-free.

However, because covered warrants are invest-

ments and spread bets arent you can use them

in a self-invested personal pension (Sipp) to manage

your risks or to boost your returns.

Thanks to the LSElisting, covered warrants offer in-

vestors a way to diversify into a number of asset classes

that may otherwise be hard to access. Our goal at RBS

is to be the retail options market, says Mr Board, so

we want to have a huge range of covered warrants.

TRADE mANy ASSETS WiThOuT

lEAViNg ThE STOCk mARkET

As well as shares, especially those in the FTSE 100,

covered warrants offer exposure to commodities, such

as gold and oil, a range of international indices, and

currencies. RBS is also planning to introduce covered

warrants on baskets of stocks in the same sector, such

as miners and housebuilders. At the time of writing,

RBS offers about 250 warrants while rival Socit

Gnrale offers 720.

Covered warrants are often seen as a way for spec-

ulators to make large profits very quickly. In reality,though, there are a wide range of warrant life-spans,

which makes them suitable for those looking to make

money over a number of months or even years, as well

as those interested in much more rapid returns.

RBS offers warrants with lives of between three

months and two years, but the most typical life-span

is between six months and a year.

pROTECT yOuR CApiTAl.

You can use covered warrants to speculate, which is

how most people think of them, says Mr Board. But

over the past six months people have been trying to

protect their portfolios in crisis times, and covered

warrants have been great for that.

A principal strategy for protecting against market

falls with covered warrants is hedging. Lets say you

have a portfolio of FTSE 100 shares worth 10,000 and,

while happy with the shares you hold, are worried

about the market falling and taking the value of your

shares with it.

You could insure your portfolio or hedge in City

speak against a market fall by buying a put war-

rant on the FTSE 100. If, for example, you purchased

2,000-worth of five-times geared FTSE 100 put war-

rants, you would receive 100 for every 1 per cent fall

by the index. This return would match the losses on

your portfolio if it fell in line with the market.

Another strategy that can be used to protect capi-

tal is known as cash extraction. Lets say you have

10,000 tied up in a single share and want to free up

some cash for other purposes. The exposure to the

share could be maintained by buying 2,000-worth of

five-times geared call warrants on the share, leaving

8,000 to keep ultra-safe in a cash-deposit account or

to put to work elsewhere.


5/12

Covered warrant jargon can seem confusing to

the newcomer, but its allbasedon some very

simple principles. Lets explore some of the

ideas and the terminology involved by look-

ing at an actual example of warrant pricing.

A warrants price is made up of two elements,

which are its intrinsic value and its time value. Thepart of a warrants price that investors tend to focus

on most is the intrinsic value. This relates directly to

the price of the warrants underlying asset such as

an index or a share which is usually simply referred

to as the underlying.

Lets take the example of a call warrant, which is

a way of betting on a rise in the price of the under-

lying. If this warrant has a strike price of 1, which

is a sort of target price, the holder effectively has the

right to buy shares at that price on a given date in the

future. (Rather than being allowed to enjoy this right,

the covered warrant receives any profit in cash.)

The investor can exercise their warrant and re-

ceive their profits on an agreed date, which is knownas the expiry date. If the price of the underlying on

this call warrant is 1.20 in the market, the warrant

would have an intrinsic value of 20p. This reflects the

fact that the warrant gives its owner the right to buy

the share at 20p less than the current market price on

the warrants expiry date. This warrant is said to be

in the money.

Were the price of the underlying to fall to 1, the

intrinsic value of the warrant would be zero as there

is no difference between the price the warrant holder

has the right to buy at and the market price. In these

circumstances the warrant would be at the money.

Now, if the underlyings price were to slip below 1,

the warrant would be out of the money and would

not have any intrinsic value.

For a put warrant which gives the owner the right

to sell and is a bet on prices going down the rela-

tionship between the market price of the underlying

and the strike price is reversed.

Assuming a strike price of 1, if the underlyingsprice fell to 80p the put warrant would be in the

money with an intrinsic value of 20p. Thats because

on the expiry date the warrant owner has the right to

sell the underlying for 20p more than it is worth. If

the underlyings price goes over 1 this warrant will

be out of the money and its at the money when the

market price is equal to the strike. Generally speak-

ing, the more in the money a warrant is the less risky

it is regarded to be and the less sensitive to changes in

the underlyings price.

But even when warrants are out of the money they

should still have some value based on the chance

of the bet coming good before the expiry date. This

is known as time value and is generally higher thelonger the warrant has left until expiry.

One misconception for a lot of people is that the

warrant price only depends on the performance of

the underlying asset, says Ben Board, Royal Bank of

Scotlands head of UK listed products. These are op-

tions with values which are subject to time decay and

volatility.

The calculation of the time value of a warrant op-

tion is complicated and depends on a number of fre-

quently changing factors. However, the good news is

that covered warrant providers calculate this portion

of the warrant price andit is then reflected in theprice

quoted by the London Stock Exchange.

AWORDABOUTWARRANTJARGONBy Algy Hall

If you want to trade covered warrants, you haveto understand some of the most commonly-usedterminology. Heres a simple guide

The spread

As when buying and sellingprettymuch anything in

financial markets, you will be

faced with two prices whenyou come to deal in a covered

warrant.There will be a higher

price that you would pay tobuy the warrant and a lower

price you would pay to sell it.

The difference between the

two is the spread.

6MASTERCLASS 9 APR 16 APR 2009

MASTERCLASS COVEREDWARRANTS


6/12

9 APR 16 APR 2009 INVESTORS CHRONICLE 7


If youre a UK investor trading traditional covered

warrants on overseas indices or commodities,

youve got to think about currency risk. Thats

because traditional warrants are traded in ster-

ling, but the underlying asset is denominated in an-

other currency.

Fortunately, Royal Bank of Scotland (RBS) hascome up with a novel way of addressing this issue

by fixing the exchange rate at parity between curren-

cies on covered warrants on overseas indices includ-

ing Dow Jones Industrial, S&P 500, Nasdaq 100, Dow

Jones EuroStoxx 50 and Bovespa. RBS has also issued

warrants on gold, silver and Brent crude oil.

So the products, which are are known as quan-

tos, are denominated in one currency, but the war-

rants are settled in another currency similar to a

spread bet. However, unlike a spread bet, you cant

get stopped out on a quanto if the underlying asset

moves against you. This is worth knowing especiallywith financial markets very volatile at present.

To see the benefits of trading quantos, consider

the example of an investor who is bullish on Brent

crude and believes that the oil price is due to break

out of its sideways pattern, in the example below.

TRADETHEWORLDIN POUNDSBy Simon Thompson

A new variety of covered warrant allows trad-ers and investors to forget about currency issueswhen trading warrants on foreign assets

JuNE2009BRENT

CRuDECONTRACT

The June 2009 Brent Crude contract

is trading at $50 a barrel.An RBS quanto call warrant,

R116, with an exercise price of $50,expiry of 11 May 2009, and parity of

10:1 is priced at 57.5p, with a tight0.5p bid-offer spread.

Therefore, you need to buy 10of these call warrants at a cost of

5.75 to gain exposure to one bar-rel of Brent Crude. And because the

quanto has a fixed conversion priceof 1:$1 this call warrant premium

equates to $5.75.So, if you held R116 to expiry,

you would need Brent crude to rise

by 11.5 per cent to $55.75 a barrelon 11 May 2009 to recoup the war-

rant premium. Right now, though,with the oil price at $50 a barrel,

the quanto has effective gearing

of 4.75 times the movement of theJune 2009 Brent crude spot price.

To bet on 1,000 barrels of

oil, currently worth $50,000,you would need to buy 10,000

quantos at a cost of 57.5p each or5,750/$5,750 in total. For every 1

per cent movement in the oil price 50 R116 will rise or fall 2.7p and

you will either make or lose 270 onyour holding of 10,000 quantos.

In turn, for every 1 movement inthe oil price you make or lose 5.40.

By comparison, most spread-betting companies require a deposit

margin of 430 times your bet size ifyou want to trade the Brent crude

June contract. So a spread bet of

5.40 per 1 movement in theoil price needs an initial depositmargin of 2,332. Therefore, the

upfront capital required for a spread

bet is less than for R116.However, if the oil price suddenly

falls by $4.30 to $45.70, the marginon the spread bet would be wiped

out. Of course, by stumping upanother 2,332 you could keep the

position open. But another $4.30fall in the oil price would wipe out

this additional margin, too.

In this scenario, the value of the

quantos would also fall, but by farless than the 4,664 margin that

would have been wiped out on thespread bet as R116 would still be

worth around 21p (or 36 per cent ofits initial value). And, of course, if

the oil price bounces back strongly,you would still have a position open

to take advantage of the recovery.This is why trading the oil price

in the short term using quantos canoffer similar upside to

spread betting, with similar tightspreads, but without the risk that

you will be stopped out if the mar-ket moves temporarily, but strongly,

against you.


7/12


THEROYALBANKOFSCOTLANDOpeg he oor o a leag Europea

Coere Warra plafor for UK eor

AdvERtisEmEnt

ABN AMRO Bank

NV (ABN AMRO)

had over 30,000

structured prod-

ucts linked to a wide

range of underlying as-sets from palm oil to pal-

ladium and the Russian

RDX index, to the RICI

enhanced Commodity

Index. On the 17 October

2007 a consortium of

banks, which included The

Royal Bank of Scotland Group

plc (RBS Group), completed the

acquisition of ABN AMRO. This acquisi-

tion opened the door for The Royal Bank of Scotland

plc (RBS), as a member of the RBS Group, to bring the

power of ABN AMROs access, infrastructure and mar-

ket-making expertise to UK private investors.The RBS listed products platform was launched in

October last year and kicked-off with Covered War-

rants. The recent unprecedented market volatility

has suited Covered Warrants well. The ability to offer

an opportunity to participate in the upward move-

ment of an underlying asset with the possibility of

uncapped returns, or the flexibility to hedge against

a downward trend enables great versatility. But it is

the ability to limit the risk of an investment that is

particularly attractive in times of uncertainty. Unlike

some other leveraged investments, investors know

their potential losses are fixed to the price paid for

the Covered Warrant, plus any commission or other

transaction charges.

Markets from RBS offer a wide range of Covered

Warrants linked to the performance of indices, single

stocks and commodities, all priced on www.

rbs.co.uk/markets. Covered Warrantsissued by RBS mainly focus on

companies from the FTSE 100

and the UKs large capital

stocks, which UK investors

are most familiar with.

However, with the im-

minent introduction

of Covered Warrants

linked to the perfor-

mance of currencies,

and the innovative

concept of basket

warrants which offer

access to several com-panies within a par-

ticular theme, RBS can

offer many new exciting

underlying assets. Un-

derlying assets in emerging

markets, such as Russia, Bra-

zil and China, as well as com-

modities such as gold, silver andoil

provide investors with the opportunity

to access new markets and diversify their port-

folio. RBS is committed to providing a regular stream

of new products with tight and consistent spreads.

Its the ability tolimit the risks of aninvestment that is

particularly attractive intimes of uncertainty

RBS can

er manyw excitingnderlyingassets


8/12


WHATISAWARRANTWORTH?by Simon Thompson

Although there are some funny Greek namesinvolved, warrants pricing is logical andstraightforward in practice

There are twocomponents to

a warrants price:intrinsic value and

time value


Its all very well having a view on where a mar-

ket or a companys share price is heading. But

choosing the right product to exploit your view is

every bit as important if you are going to maxim-

ise the profit potential on offer. Knowing how to value

a warrant will help you enormously when deciding

how best to play your idea.The three most important criteria when valuing a

warrant are: the underlying price of the asset that the

warrant tracks; the time to expiry of the warrant; and

its implied volatility. Dividend income and the level

of interest rates should also be considered but these

generally are of secondary importance.

UNDERlyiNgpRiCE

There are two components to a warrants price: in-

trinsic value and time value. When the exercise price

of a warrant is below the underlying price of the as-

set (for a call warrant) or above it (for a put warrant),

then the warrant has intrinsic value. In other words,part of the warrant premium is in the money.

However, warrants also have time value, which

is the part of the warrant premium that is out the

money. Its worth noting that the proportion of time

value accounted for in the price of a warrant with in-

trinsic value increases the closer the exercise price of

the warrant is to the underlying price of the asset. In

effect, the warrant premium becomes more of an

investment along with the probability that the

security will move in your favour between thepurchase date and expiry of the warrant.

All things being equal, the time value pro-

portion of the warrant price will reduce more

quickly the nearer a warrant is to itsexpiry date

for the obvious reason that a short-dated war-

ranthas less timeto movein your favourthan a

long-dated one with the same exercise price.

It is important to note that the deeper a

warrant is in the money, the less time value

you should be paying in the warrant premium.

In the most extreme cases, some call warrants

act as geared trackers and put warrants as re-

verse geared trackers as they are so heavily in the

money that virtually all the warrant premium is ac-counted for by intrinsic value. To illustrate how this

works in practice, consider the following example of

a FTSE 100 call warrant.


9/12

9 APR - 16APR 2009MASTERCLASS 11

Summaryn Warrants with significantintrinsicvalue act more likegeared trackers, so changes inimplied volatility have less im-pact on warrant pricing.Timedecay is also less of an issueas the FTSE 100 examplesillustrate.

n Warrants that haveexercise prices close to themarket price of the underlyingsecurity will have greater timevalue element and changesin the impliedvolatility of thewarrant will have a greaterimpact on the warrant pricing.As a result, the time decay willbe greater, too.

n The riskiest warrants are

short-dated and out of themoney.These have the high-est effective gearing levelsas theyare most sensitive tomovements in the underlying.These have the greatest risk ofexpiring worthless.


TimEVAlUE, ANDTimEDECAy

Of all of Royal Bank of Scotlands (RBSs) FTSE 100

covered call warrants in issue, R071 has the longest

time to expiry, maturing on 16 September 2010, and

with a strike price of 3000 it also has the lowest exer-

cise price. Parity is 1,000:1, which is normal for FTSE

100 index warrants.

So, with the index trading at 3800, the warrants

which have 18 months to expiry are priced at 104p

each. In other words, a purchase of 1,000 call warrants

means we are paying the equivalent of 1040 points to

buy the index at 3000.

This looks like a fair price because almost 80 per

cent of the warrant premium is in the money, split 800

points (or 80p of the warrant price) of intrinsic value

and only 240 points (or 24p per warrant) of time value.

By contrast, Socit Gnrales FTSE 100 covered

call warrant, SI39, has an expiry date one year ear-

lier on 18 September 2009, an exercise price of 3800

and parity of 1,000:1. With the index trading at 3800,

the warrants which have six months to expiry are

priced at 35p each. So, a purchase of 1,000 warrants

means we are paying the equivalent of 350 points to

buy the index at 3800, all of which is time value.

As a result, R071 acts more like a lowly geared in-

dex tracker because the time value of 240 points has a

lengthy 18 months to decay. This warrant has effective

gearing of 2.7 times the movement in the underlying

index, so a 1 per centrise inthe FTSE 100 from 3800 to

3838, would increase the call warrant price from 104p

to 106.8p, ora 1 per centfallin the index would reduce

it from 104p to 101.2p.

By contrast, SI39, which has effective gearing of

five times, is far more sensitive to movements in theFTSE 100 due to its shorter time to expiry and the fact

it is trading at its exercise price.

Whats more, the time decay of SI39 will be far

greater. This is also known as a warrants theta, or

the sensitivity of a warrants value to the passage of

time. Theta shows the fall in the warrant price for one

day with all other factors remaining constant and is

expressed in pence a day.

Remember that the theta per day accelerates as

warrants near maturity as the time value element of

the warrant falls.

Deep in-the-money call and put warrants gen-

erally have low thetas or time decay as the majority

of the warrant premium is accounted for by intrinsicvalue, so more of your warrant premium is protected

from capital erosion if the underlying security fails to

make any progress. Thats why buying the longer dat-

ed R071 call warrants with their lower exercise price

is a more risk averse way of playing any upside in the

FTSE 100 than buying the shorter dated SI39.

R071 may have lower effective gearing than SI39,

but the warrants will retain a higher percentage of

their value if, by 18 September 2009, the FTSE 100 is

still tradingat 3800. Forexample, using RBSs warrant

calculator on their website, R071 would fall by almost

8 per cent in value from 104p to 96p by that date if

the index is still trading at 3800, reflecting the loss of

8p per warrant (80 points on the index) of time value.

The warrants would still retain around 16p per war-

rant (160 points) of time value and 80p (800 points)

of intrinsic value.

By contrast, holders of SI39 would see all of their

investment wiped out if the FTSE 100 was trading at

3800 on 18 September 2009 because the call warrant

would have no intrinsic value.

impliEDVOlATiliTy

Volatility is also a part of a covered warrants price

and represents the magnitude of the underlying se-

curitys movements during a specific time period and

can be calculated using the annualised standard devi-

ation of its return. However, when pricing a warrant,

volatility is anticipated (or implied) as it estimates the

probability that the warrant will expire in the money

or more deeply so.

When valuing a warrant, it is therefore important

to realise that rises in implied volatility will increase

the warrant premium, while falls in implied volatility

lead to falls in warrant premiums.


10/12

The credit crunch has given leverage a bad

name. But, used responsibly, leveraged prod-ucts remain a great way of boosting invest-

ment returns.Heres a simulated example to demonstrate the le-

verage benefits of warrants. Using the Royal Bank of

Scotlands (RBS) warrant calculator, we cansee how aleveraged trade can produce returns way in excess ofan unleveraged product such as shares, commodities

or exchange-traded funds (ETF). However, just likethese assets, covered warrants can be held in a Sipp.

Warrants can be used to trade movements in a be-wildering array of underlying assets, but were going

to use crude oil as the underlying for this example.Brent crude has enjoyed steady gains since bottom-

ing at $43 a barrel in mid-February. However, accord-ing to our technical analysis, it is looking ready for a

fall having hit $50, perhaps to as low as $30 a barrel.One simple way to trade this idea would be by

using the Short Crude Oil ETF from ETF Securities,

which is listed on the London Stock Exchange (ticker:SOIL). The fund essentially acts as a mirror image ofthe oil price, rising as the value of the Dow Jones AIG

Crude Oil Sub-Index falls. That means there is no le-verage the value of the ETF changes by minus one

times (-1x) the daily percentage change in the index.But, if we were to use a covered warrant to make

a similar trade, a 20 per cent fall in the price of Brentcrude would see a much higher return.

The level of gearing you can achieve on a cov-ered put warrant depends on two main factors: the

strike price and whether the warrant has any intrin-sic value and the time to expiry. The easiest way

to show this is to simulate trades using a variety of

warrants. At the time of writing, RBS had eight putwarrants available on Brent crude futures four with

June expiry and four November dated, across a rangeof strike prices.

For our first trade, lets play safe and go for a putwarrant with a November expiry thats already in the

money ie, the underlying is trading below the strikeprice. With a strike price of $80, the RBS put warrant

R133 looks perfect even if the trade goes wrong,theres a lot of headroom from the current $59 price

of the Brent November future before the warrant be-comes worthless. Using RBSs covered warrant calcu-

lator, we can see that a 20 per cent fall in the value ofthe underlying to $47 over the next month results in a

37 per cent increase in the value of the warrant.If that level of gearing doesnt sound particu-

larly attractive, it may be worth considering a short-dated June future with a much more aggressive

strike price. The R123 put warrant with a strikeprice of $50 is currently out of the money and,

with little more than a month to move intopositive territory, it is a much riskier propo-

sition than our first example. But the payoffis that the gearing of this warrant is much

higher. If the oil price falls 20 per cent from$53.5 to $42.5, the warrant will increase in

value by a massive 106 per cent over thesame time period.

RBSs put warrants on Brent crude futuresalso provide the added benefit of removing

exchange-rate risk from the trade a usefulfeature given that the volatility of asset values

has lately been left in the shade by the extremevolatility of currencies.

SUPER-CHARGEDPROFITSWITHWARRANTSByJohn Hughman

Leverage is how you turn modest moves into big returns. Butwhile covered warrants provide leverage, their downside risks arestrictly limited

12MASTERCLASS 9 APR - 16 APR 2009


Used responsiblyleveraged produc

remain a greatway of boosting

investment return


11/12

9 APR - 16 APR 2009 INVESTORS CHRONICLE 13


Although leveraged products such as covered

warrants are often seen as a racy way to

boost returns, they can also come into their

own as a way of laying off risk elsewhere in

your portfolio. When stock markets are experiencing

extreme volatility, they are a useful tool for cautious

investors who wish to smooth out their returns.You can use covered warrants to lay off the risk of

an entire portfolio of FTSE 100 shares by taking out

a FTSE 100 put warrant, which would gain value as

the market and your portfolio fell. Likewise, covered

warrants can be used to hedge a particular holding in

your portfolio. Company-specific problems are typical-

ly less predictable and more severe than entire market

issues, leading to sharp falls in a firms share price.

Were you to sell a portfolio of shares because you

feared a market drop, you might crystallise a big capi-

tal-gains taxliability in doing so.Also, when you came

to buy them back later on, youd incur stamp duty.

While hedging makes more sense for investors fo-

cused on preserving capital, younger investors, whohypothetically can absorb larger losses, may be tempt-

ed to consider hedging, too. Thanks to the wide range

of covered warrants available, investors can use them

to cost-effectively insure against a drop in value of un-

derlying assets including equities, indices, currencies

and commodities.

As an example, lets look at a scenario where an

investor has a holding of 1,000 shares in AstraZeneca

worth 22,750 which have climbed 22 per cent in the

last year. Because of the attractive dividend the com-

pany pays, our investor wants to retain his holding,

but is worried that the shares may come under pres-

sure if defensive stocks fall out of favour.

There are two ways he can implement hedg-

ing with covered warrants: static hedging and

dynamic hedging. A static hedge is the most

basic approach, but doesnt fully protect

against losses as it assumes that the put

warrants are held to expiry and there-

fore removes time value. Calculating thenumber of warrants required for a static

hedge can be done by dividing the val-

ue of the holding by the strike price of

the warrant and multiplying by parity.

Dynamic or delta hedging is

more complicated, as our investor has

to frequently reassess the number of

warrants needed to hedge his position.

But the advantage of dynamic hedging is

that, if implemented correctly, it will fully

insure against any downside. The number of

warrants required for a dynamic hedge can be

calculated by dividing the number of shares to be

protected by the delta of the warrant which changesover time, hence the need to reassess the hedge and

multiplying by parity. Both static and dynamic hedges

can be worked out using hedge calculators available

either from the LSE or from warrant issuers.

In our example, our investor requires 10,200 war-

rants priced at 22p each to implement a static hedge,

although this will cost 2,300 to implement and will

only cushion losses by 350 should the value of the

underlying fall by 15 per cent (the overall position will

fall instead by 11.6 per cent). A dynamic hedge, on

the other hand, will require 22,390 warrants at a cost

of 5,463, but should theoretically provide a perfect

hedge against a fall in value of the shares.

CONTROLYOURRISKSWITHWARRANTSByJohn Hughman

Although best known as speculative tools, covered warrants canbe used to protect as well as to grow a portfolio

Covered warrantscan be used to

hedge a particulaholding in your

portfolio


12/12

MASTERCLASS

WHYWARRANTS?

By Dominic Picarda

Coveredwarrants are just one typeofderivative.So how do they compare to the competition?

You really are spoilt for choice when it comes

to trading financial markets these days. To

get exposure to a particular asset, you can

either buy or sell the actual asset, such as a

share, index tracker, a foreign currency or a commod-

ity. Alternatively, you can deal in a wide range of de-

rivatives: products that are based on these real assets.

Covered warrants are just one kind of derivative,

so why would you want to deal them rather than, say,

spread bets, contracts-for-difference (CFDs), futures

or options?

Gearedprofits, limited riskLike most derivative products, covered warrants are

geared. This means they can turn a small price move-

ment in whatever asset youre trading into a big profit.

However, the wayin which theyre geared is somewhatdifferent from CFDs, spread bets, and futures.

The key point is youre never going to wake up one

morning and find youre bankrupt, says Ben Board,

of Royal Bank of Scotland (RBS). With covered war-

rants you can never lose more than you paid for the

warrant itself.

The worst outcome possible is just that a warrant

expires worthless at the endof its life.Thismeans your

maximum potential losses are known right from day

one: the price of the put or call warrant you buy. This

is similar to a fixed-odds financial bet or a purchased

option, where your losses are known in advance and

are limited to the cost of the bet or option premium.

There is no such certainty when trading spreadbets or CFDs. If youre betting on something to fall,

you can end up with unlimited losses, as there is no

limit to how far an asset can rise.

If you already deal in ordinary shares, you should

be able to buy and sell covered warrants through your

existing stockbroker. By contrast, you would have to

open a new account in order to trade spread bets,

CFDs and most other derivative instruments.

Like ordinary shares, covered warrants are listed

on the London Stock Exchange. This means their pric-

es are visible within a familiar setting. Financial bets

both spreads and fixed-odds as well as manyCFDs

are not dealt through a central market.

aGrowinG familyofproductsThe choice of what you cantrade via covered warrants

is growing all the time. Admittedly, the selection isnt

yet on a par with spread betting, CFDs or futures and

options. CFDs and spread bets in particular provide

access to a huge range of equities, whereas only the

largest are available through covered warrants.

Nevertheless, in addition to leading shares, you

can also trade entire stock indices, commodities and

foreign exchange. This is a broader selection than is

available via fixed-odds financial bets. RBS is plan-

ning to launch warrants that track broader areas

within the stock market, such as medium-sized oil

companies and housebuilders.

flexible& efficient

Whereas winnings from spreads and fixed-oddstrades are tax-free, gains on covered warrants are lia-

ble for capital gains tax at 18 per cent. Thats because

as with CFDs, futures and options covered war-

rants are classified as an investment product rather

than a wager.

As investment products, you can use covered war-

rants to hedge risk or to gear up returns within

a self-invested personal pension (Sipp). This

cannot be done with financial bets and,

although CFDs can be used in a Sipp, it

involves a special account.

Even though they trade on the

London Stock Exchange like

shares, covered warrant trans-actions do not incur stamp

duty.

When you buy and sell

warrants, you will pay com-

mission to your stockbroker

as you would when buying

shares. This tends to be a

flat fee, perhaps as low as

10 a time. By contrast, CFD

brokers charge around 0.2

per cent when both buying

and selling.

MASTERCLASS coveredwarrants

14MASTERCLASS 9APR - 16 APR 2009

The key point isyoure never going

to wake up onemorning and findyoure bankrupt

Coveredwarrantsguidevincestanzione

Documents