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Covered Warrants I

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4. Advantages of warrants

There are advantages and disadvantages to covered warrants, and it is essential to be aware of both before investing. Only by considering both sides of the coin can you hope to make an informed judgement about whether these are the right instruments for your needs.

Gearing and Leverage

In general, the gearing property of warrants means that price changes in covered warrants will exaggerate movements in the underlying assets. Gearing is the primary attraction of warrants [and because of this, we examine gearing in greater detail elsewhere in this course].

Unlimited gains, limited losses

The combination of limited losses with unlimited gains for call warrants constructs a powerful argument. If you invest £1000 in warrants then no matter how badly your investment turns out, you cannot lose more than £1000. Your loss is limited to the money you put in. It is a first-rate feature of warrants that your maximum loss is known in advance, unlike, say, futures and spread-betting.

Accessibility

To deal in covered warrants you simply need to ask your stockbroker no new account is required. It is not difficult to get started, especially if you are already used to trading in shares - warrants essentially work in the same way, with largely the same method of dealing.

Transparency

The covered warrant market has the considerable benefit of transparency. You can see what is going on, which means you can also see whether you are getting a fair deal. This is not always true in other markets. If you are taking out a spread bet, for example, how do you really know that you are dealing at the best price the market has to offer - there is no central trading platform!

In contrast, the centralised listing and trading arrangements for covered warrants mean that all prices are very easily accessible to enable a full comparison and choice. The market is fully transparent, right down to the reporting requirements which mean that trades must be reported within three minutes.

Good Liquidity

Unlike the traditional UK warrant market, liquidity should not be a problem in the covered warrants market because the issue sizes are larger and because the pricing system is established with the issuer in a facilitative role.

Low transaction costs

The costs of dealing in covered warrants are not high. If the costs are broken down from start to finish, covered warrants score well on all counts, with a bulls-eye along the way.

Stamp duty
Opening an account and dealing costs are as low as that for shares - stockbroking is a highly competitive market now. But the big attraction is that cash-settled covered warrants will be free of the annoying 0.5% stamp duty levied on share trading.

Bid-offer spreads
Pleasing though the absence of stamp duty is, it pales into insignificance alongside the dealing spread, which is a far larger component of the overall cost of dealing. And there is every sign that dealing spreads will be tight in the new market. For covered warrants, maximum spread rules will be applied to warrants traded on the order book, either the greater of 10% on the bid price or 1p, but in practice dealing spreads are likely to be far narrower.

Designed as a retail product

Covered warrants have been specifically designed for private, or in the industry parlance, retail investors in the UK. Private investors are welcome and are in no way going to be treated as secondary to large institutional investors.

This is a realm in which private investors really matter. Clients will be wooed by the issuers and protected by the regulators, and for many smaller clients it will make a refreshing change to be in pole position.

Opportunities in bull and bear markets

Using put warrants as well as call warrants means that certain warrants can prosper in bear markets as well as bull markets.

Sceptics may argue that the availability of put warrants is of little value if no-one uses them. This may be a fair point, but experience in overseas markets is the same as for spread-betting in the UK. During extended downturns investors will begin to take short positions: the put to call ratio (the number of puts traded divided by the number of calls traded) in the Australian options market, for example, rose from 0.7 at the end of 2001 to 1.4 at the end of July 2002.

Aid to diversification

For smaller investors, the lower price of covered warrants can be used to help portfolios become more diversified.

Example

An investor with £5000 to invest in shares may decide that £1000 is the minimum efficient investment in each. The resulting portfolio of five shares will necessarily be concentrated and vulnerable to poor performance if the selections prove to be unfavourable. Using covered warrants, the same exposure to those five shares could perhaps be achieved by an investment of £2000 in total, or £400 per warrant. This allows the balance of £3000 to be used for further purchases which may broaden the sector or geographical base of the portfolio, lessening the dependence on individual stock performance and reducing overall volatility.

Ability to invest in assets otherwise unavailable

Warrants can also improve your investment reach. Using covered warrants listed on the London Stock Exchange investors should have the ability to play all kinds of markets and views, some of which were previously too difficult or expensive to consider. This is particularly true for warrants which may be issued on currencies, commodities, baskets of shares, and overseas instruments.

Stock Exchange listing

Covered warrants will be listed on the London Stock Exchange and traded according to its rules. This unmatched legitimacy is a comforting background for investors risking capital by investing in geared products. It is a huge advantage over competing instruments such as spread betting.

Without wishing to disparage the spread-betting firms in any way, investors can feel confident that the LSE will maintain orderly markets with properly maintained bid and offer prices and spreads during good times and bad.

Provision of information and education

Issuers make their money from margin built in to the premiums and dealing spreads, and if the market fails to thrive then it fails commercially. They have every incentive to support the market and to ensure as far as they can that investors understand the market, enjoy their trading, make good profits, tell all their friends, and come back for more. This is why issuers are eager to promote the market with advertising, articles, guides, seminars, web sites, and other promotions to attract investors.

One huge advantage of the new market is that it will be served by some very sophisticated data providers. Not only is data provided, but some sites allow the data to be manipulated to simulate certain outcomes. Web sites are being developed all of the time, so any comment is bound to become out of date, but for now one really nice feature to be found on some sites is a warrant simulator which allows users to change certain variables and to see in real-time how these might affect warrant prices.

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