In troubled times, traders look to flexible tools to maximise profits
MARKET volatility during the financial crisis has meant that many investors have dived for cover and taken their money out of the markets. But that’s not the case for everybody. What is stormy weather for some is exciting for others, and those who like to plunge into volatility have been looking at the wide range of derivative products as a means of taking advantage of fluctuations.
Covered warrants are particularly suited to volatile markets and as such are looking increasingly interesting to private traders. These instruments are essentially options, packaged in a retail-friendly format that private investors can access easily through stockbrokers, making them straightforward to use for anybody familiar with options trading.
Put simply, covered warrants give buyers the right, but not the obligation, to buy or sell the assets that the warrants are based on at a fixed price on or before a set date in the future. So if you believe that the FTSE 100 will rise further from the current price, then you would buy a call warrant on the index whereas you would buy a put warrant if you believe the index will see another drop lower.
The way it works is this: you buy a covered warrant from an issuer, for anywhere between 10 and 50p. As brokers costs would apply to the purchase, then traders tend to buy at least £200 of covered warrants. You can take up the option to buy or sell the asset at an agreed level at a set date.
So, for example, if you thought that a share will be worth more than £1 on 1 January, then you could buy a covered warrant that gives you the option to buy the share for £1 at that date. Your profit is the difference between the price that you paid, and the actual price at that date. The position is cash-settled, meaning that the payout would automatically be delivered to your stockbroker account. Another benefit is that your losses are limited to the cost of the covered warrant.
STRIKE PRICE
Covered warrants come with a wide variety of expiry prices – known as the strike price – and expiry dates. For example, if you predict that the FTSE 100 is going to rise in the future then RBS offer 30 call warrants ranging from 17 September to June 2010, with strike prices ranging from 3,000 to 5,750. Societe Generale, the other major covered warrant supplier in the UK, offers around 60, with strike prices from 3,600 to 10,000, as far forward as December 2012.
As well as pure speculation, covered warrants can also be handy for hedging positions. Ben Board, sales director at RBS Listed Products, says: “People who have stock portfolios saw huge losses as stocks fell last year and they have bought put warrants on the FTSE 100 to mitigate their losses,” If you thought that the index will rise over the next 12 months and therefore would be loathe to sell your shares now but equally thought that the equity rally was overextended, then you could buy a put warrant on the FTSE 100 as a hedge.
CRYSTALLISING GAINS
But because covered warrants are exchange-traded and are listed on the London Stock Exchange (LSE), their price is transparent and is an accurate reflection of the supply and demand in the market. What’s more, it means that you can sell your covered warrant at any point before expiry, either to crystallise your gains or losses prior to the expiry. Typically, though, investors don’t hold covered warrants until expiry, preferring to lock in what they have made.
But while the FTSE 100 is the most popular traded covered warrant, traders have been attracted to a number of other assets. Societe Generale, which has around 800 covered warrants listed on the LSE covering a variety of UK assets, has seen an increase in the trading of currency covered warrants, especially cable, because of the volatility of currency pairs are at the moment. It says that copper and aluminium have also been popular covered warrants.
RBS’s commodity index covered warrant has been particularly popular lately. RBS also says that the covered warrants on the Brazilian stock index has been extremely popular lately because of the volatility that emerging market indices offer.
One of the main advantages of covered warrants is that, like spread betting and contracts for difference (CFDs), they are geared, which allows traders to make a greater percentage profit than the percentage move in the underlying asset price.
This means that traders can benefit significantly from sharp moves in the price over a period of time, which of course are more accentuated in volatile markets. And even though volatility has dropped off from last October’s highs, gearing still allows you to capitalise on what remains. If you plan to get involved in the markets at the moment, this is one way to make the most of troubled times.