LOCK IN YOUR PROFIT BUT STAY EXPOSED
ALEXANDRE HOUPERT
HEAD OF LISTED PRODUCTS UK, SG
CORPORATE & INVESTMENT BANKING
FOLLOWING strong rallies in global equity markets, many traders are now keen to extract some of the profit that they have earned on existing positions to free up capital and to protect themselves, should we see a pullback in stocks. However, these same investors will also want to maintain exposure to their positions, just in case the market continues to rally.
Call covered warrants are one way of keeping your exposure the same but releasing your cash. Their leveraged nature means that you will invest less than if you opened a position in the equity itself. You will get the same exposure to the upside but because losses are limited, you will protect your portfolio.
For example, using this strategy on the mining giant Rio Tinto could be useful considering its share price has risen roughly 128 per cent since the start of the year. As an example, if you have a portfolio of £30,000 composed of Rio Tinto shares, you could buy call covered warrants rather than keep the physical stock. Thanks to the leverage effect, you will need to invest less and that cash could be used to buy other shares or saved.
Investors looking to extract their cash in such a way should first define the timeframe and what they think will happen to the share price. As a rule of thumb, when picking your covered warrant, you should select one with a delta of between 30 and 60 per cent and which has a maturity date that is three times further into the future than time you think it will take for your view to be realised. This protects you from the erosion of time value.
Returning to the Rio Tinto example, let’s assume that the chosen covered warrant is provided by a gearing effect of 5x, an investor would need to buy only £6,000 to retain the same exposure to the underlying asset as you had when you owned the physical stock, leaving £24,000 to be cashed out.
But investors have to bear in mind that the underlying has to increase for the break-even level to be reached and the cost incurred from buying to be compensated.