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What are Covered Warrants
A covered warrant is just a long term option -
see introduction to Options.

Options usually expire within 1 year but a warrant can last for up to 5 years. And the word 'covered' means that no stock is issued from the company should the warrant be exercised.

Covered Warrants were introduced on the London Stock Exchange around 2002 with a lot of publicity. But the market has never taken off. Why is this?

Probably because of two reasons -

1. Retail investors in the UK for whatever reason, have never taken to the options markets. The volumes are pathetically low in relation to the capitalisation of the overall stockmarket and in regards to the incredible amount of options business done on the continent. The odds against them succeeding were always low.

2. Some consider warrants expensive in relation to similar option products.

The article below, from the November 2003 issue of Futures & Options World does a good job in summing up Covered Warrants.

"Covered warrants are not going to be big in the UK, whatever the time frame. This may be a broad statement to make and just because they have had considerable success in certain European countries, there is absolutely no reason to believe that a similar pattern will be repeated in the UK.

I first came across covered warrants in the late 1980s when I was a foreign exchange trader. The German subsidiary of the bank I was working for listed some currency warrants and covered them with an over-the-counter option. The amount of money it made was staggering, especially as it had virtually no risk left on its own book. Being a typically cynical trader, the only conclusion I could arrive at was that someone must have been well and truly ripped off.

A decade and a half later, I am convinced that this judgement was correct. In the intervening years, nothing has fundamentally changed. If I am charitable, I would describe covered warrants as a poor value product. If I were more open, I would describe them as a complete and utter rip off - a product that retail investors should be educated to avoid. There is little need to educate wholesale or professional players, because they know this already.

This is one of the great mysteries about the launch of covered warrants in the UK. Ask any professional option market participant for their view on covered warrants, and you will undoubtedly be told that they are indeed extremely expensive. However, because they could be a lucrative product for the banks writing them should they prove popular, a code of omerta exists. This means that very few professional traders and brokers will state the simple fact that warrants are generally far more expensive than comparable options.

A feature of the covered warrants market is that investors are not allowed to sell them. So there is a tendency for them to be priced extremely expensively at launch, when the retail market will supposedly buy them. They then tend to get cheaper, at least versus similar options, as they near expiry, when any mug punters, or retail investors, still long will be looking to sell.

There are numerous examples of how expensive they are. One is the 150p covered warrant call on UK mobile telecom Vodafone expiring June 2004 issued by Goldman Sachs. This is bid 6.35p. The listed 150p June call option listed at Euronext/LIFFE is offered at 4p, a discount of 37% to the warrant's bid.

The poor value extends to other asset classes. For instance, a 1.60 sterling call versus the dollar (cable) covered warrant offered by SG and expiring June 7, 2004, is bid at 26p. The offer price for an option with exactly the same details is 19p in the interbank market.

Julian Quinn, head of options at spread better City Index says: "The whole thing about covered warrants is that they've been designed to allow institutions to sell expensive volatility.” Quinn claims that some of the warrants based on FTSE-100 options are currently being priced off implied volatilities around 35%, while the true level in the market is 18.5%.

In recognition that covered warrants can potentially be viewed as a rip off, one private client broker in London says that anybody who actually sells one to a customer must point out that similar products are often available at a far cheaper price. If they do not do this, then they run the risk of misselling.

Bruce Williams, an investment director at BWD-Rensburg, voices a similar opinion. "What's so stupid is that there are similar products available with exactly the same risk profile and which are far cheaper," he says.

David Lake, head of UK warrants at SG, naturally does not share the view that covered warrants are a rip off. He says they are a product range that is distinctly packaged for the retail market. Previously, this may have been used to justify their relative expense versus comparable options, much in the same way as the Thomas Cook price for cable is considerable wider and significantly lower or higher, depending on which way around you are, than the price quoted in the interbank foreign exchange market.

However, the distinction between retail and wholesale financial market prices has rapidly diminished. Most exchanges at least claim that their markets are fair to all participants. Even in the more opaque asset class of foreign exchange, investors can access market rates in virtually any amount, however small or big.

So is there anything at all that can be said in favour of covered warrants?

Lake says that there are plenty. "Warrants are issued on underlyings which are otherwise difficult and expensive to access for the average UK investor - European indices, gold or one year Aviva calls to name a few; they can be held in a SIPP, allowing investors to hedge their pensions against market falls and they offer the tightest bid-ask spreads on many UK blue chips for any related product, such as options, CFD or spread bets. Around 80% of our trading is short term, by professional investors,” he says.

Lake claims this is an important factor and that the tightness of the spreads on covered warrants goes a long way to compensating the fact that investors are buying a product that has been priced off what looks to all extents and purposes too high a vol.

"If you're buying (a covered warrant) and holding to expiry, then its reasonable to look at products offered by LIFFE," Lake adds. "If you want to wing in and out within a couple of hours, then warrants are a more viable product as commission rates are lower and spreads are tighter . The spreads on LIFFE can be diabolical. The current spread for a March 04 AstraZeneca 2800 call option, for instance, is 18.4% on LIFFE, on our warrants the spread is 0.39%," he concludes.

The last point is an extremely valid one in the defence of covered warrants. Few professional option participants would trade on many of the rates shown on LIFFE's screens. What they are far more likely to do is to ring up market makers to obtain tighter prices or to put orders on within the spread. But can retail investors do this as easily and is this a limiting factor in the appeal of listed options for the sector? In short, the price of crossing the spreads on many options rules out frequent trading in and out.

However, I cannot believe that covered warrants will prove successful, because ultimately spreads will tighten on equity options. The fact that they are a far cheaper product will ultimately prove to be their key advantage over covered warrants, especially when this fact becomes more widely known by retail investors. "

The above article appeared in Futures & Options World Magazine

LearnMoney.co.uk Comment -

Covered Warrants do seem expensive compared to options and you can't sell them short which makes them somewhat inflexible products.

However they do, as David Lake, Head of Warrants at SG states, have one small advantage over options - the bid-offer spreads are tight and that can help to drastically reduce costs.

As the article suggests if you're the kind of trader who likes to buy options looking for a quick turn over a few days or a week then why not at least consider warrants. Check the prices, run them through your option software and see if the trade makes sense.

I personally don't trade warrants as I'm a long term investor in stocks. But if I were a short term trader I'd defiantly put them on my radar.

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