Covered warrants: Ins and outs of calls and puts

Simon Hildrey explains why the covered warrants market flourishes under current volatile conditions. The prices of oil and gold have been more volatile than usual in recent months, reflecting the fluctuating prospects for Middle Eastern peace. These conditions are ideal for investors hoping to trade on this volatility. Goldman Sachs International now offers a cost-effective way for private investors to speculate on future oil and gold prices through covered warrants. These warrants allow investors the right to buy (calls) or sell (puts) gold or oil at a specific price within a certain period of time. Investors may, for instance, feel confident of investing long or short in these commodities over the next few months. Goldman Sachs includes in its product range one oil covered warrant and three gold covered warrants that mature in November. At approximately Ł12 (E17) a trade, covered warrants are cheaper and more accessible than trading the futures contracts themselves. The covered warrants market is well established in continental Europe, particularly Germany, Switzerland and Italy. There are more than 50,000 covered warrants listed in Europe, offered by 40 issuers with a total value of E290bn. In 2002, Europe’s covered warrants market saw a total turnover of E75bn, with approximately 85,000 daily trades. Risks and applications The risk for clients investing in covered warrants is that they can lose their entire initial investment. If a German investor buys a call on BMW but its share price fails to increase during the term, he loses his investment plus brokerage costs. The term can range from weeks to years. The shorter the length of the covered warrant, the cheaper for the investor to buy it. Covered warrants attract a higher risk than investing directly in shares. A relatively small movement in the underlying security’s price triggers a large movement in the warrant price. This can be favourable or unfavourable to the investor. But it means covered warrants can be more volatile than normal shares. Selling a “put” on a covered warrant is less risky than traditional ways of shorting an asset. An investor going short on a share through a covered warrant knows the maximum loss is 100 per cent of the investment. By contrast, going short through options can lead to unlimited losses. Investors can use covered warrants to sell a put to hedge other investments in a portfolio. If the investor buys a share, confident it will rise in the long term but less certain about the short term, he can provide “insurance” against a fall by selling a “put” on the same stock. Increased exposure One of the main advantages of covered warrants is that they enable clients to leverage their investments. Buying call warrants rather than shares directly in the stock market can increase an investor’s exposure. For example, if an investor buys BMW shares at 159p and they rise to 189p, the return is 19 per cent. But buying the equivalent “call” warrant at 20.3p and selling at 39.2p, gives the investor a 93 per cent return. Mark Valentine, executive director of the equities division at Goldman Sachs International, says that as well as ensuring tight bid offer spreads, “it is important for issuers to provide a broad range of products with various maturity dates”. Goldman Sachs, for instance, provides currency covered warrants in addition to commodities. “We also provide information online about prices, bid offer spreads and the volume of trading,” he adds. Europe’s markets In Europe, investors have focused on covered warrants of shares and indices on their own stock markets. Indeed, Toby Peters, vice-president, equity derivatives marketing at JPMorgan, says of 30,000 covered warrants in Germany, only about 5 to 10 per cent are actively traded every month. European covered warrants were first launched in Germany in 1989, and Germany is now the Continent’s largest market. In 2002, Germany’s turnover was E17.5bn compared with E16.5bn in Italy and E16bn in Switzerland. France, Europe’s next biggest market, trails with E2.8bn. The UK, where covered warrants were launched on 28 October 2002, is still a very small market in comparison and has a much smaller range than other markets in Europe. Turnover of covered warrants reached just Ł9.5m (E14m) in March, although this was an increase over the Ł3.7m in February. UK brokerages have criticised the London Stock Exchange (LSE) over this low level of turnover, five months after the introduction of covered warrants. This has not helped the Exchange’s chief executive, Clara Furse, whose interest in covered warrants derives from her derivatives industry background. But the four active issuers in the UK have defended the LSE, arguing that covered warrants were introduced at the trough of private investor interest in stock markets. They say turnover jumped in March, after growing steadily from Ł1.4m in November. One encouraging aspect of the first five months, says David Lake, head of UK warrants at SG investment bank, is the fact that 30 per cent of those traded have been “puts”, one of the highest proportions worldwide. Private investors generally shun “put” warrants. Institutional Swiss Switzerland’s covered warrants market is different from the rest of Europe, because it is dominated by institutions, rather than private capital. With an average investment of E4500, covered warrants are dominated by private investors across the rest of Europe. Mr Lake says 90 per cent of trades are carried out by private investors in Europe, apart from Switzerland, where 90 per cent are institutional. Germany is unique, adds Mr Lake, because it is the only market in Europe where 50 per cent of trades are carried out “completely off exchange”. “They tried to introduce a centralised platform but failed in Germany. Brokerages trade directly with the issuers,” says Mr Lake. Online brokerages have become an important part of the market in Germany and Italy, says Mr Lake. In these two markets, more than half of the trades in SG’s covered warrants have been carried out online. “In these volatile markets, investors want to be able to trade quickly and capitalise on rises in share prices rather than have to phone a broker,” he says. Mr Lake says SG centralises its covered warrants traders in Paris for the whole of Europe. This reduces costs as SG does not need to employ traders for every market. He argues it also helps to tighten spreads and improve liquidity by aggregating all the trades across Europe. “This gives us more buying power,” says Mr Lake. “It is important for issuers to maintain liquidity and tight bid offer spreads in any market conditions. When markets collapse, such as on 11 September 2001, some issuers stop producing prices.” Mr Lake adds that investors should look at how consistently covered warrant prices move in line with the prices of the underlying security. “Animation systems can ensure the prices move together but some issuers still change prices manually.” Customer demand Another recent European trend has been a move away from individual stocks towards investing in indices through covered warrants. According to Henrik Takkenberg, head of public distribution at Commerzbank Securities, this has occurred in conjunction with a reduction in the length of time covered warrants are being held by European investors. “Index covered warrants have tighter spreads and higher liquidity than individual stocks because of their lower volatility. This makes index covered warrants cheaper,” says Mr Takkenberg. “About 70 to 80 per cent of demand from private investors is now for index covered warrants, primarily from their domestic stock markets. Demand for index products has grown compared with individual shares because of the increased volatility of stock markets. “Investors can carry out better technical analysis of indices than single stocks. Furthermore, stocks can lose 40 or 50 per cent of their value in one day because of corporate issues as we have seen with Ahold and Bayer. The length of time investors are holding covered warrants has been reduced dramatically as well from an average of two weeks to one or two days.” To assist investors, Mr Takkenberg says Commerzbank Securities provides information on the level of turnover in covered warrants, level of gearing and where is the most and least demand. Domestic shift Alex Klatt, head of pan-European covered warrants distribution at Citigroup, agrees that over the past two years investors have moved away from covered warrants on international underlyings, particularly the US and Japan, towards domestic equities and indices. “The majority of the demand in Germany, France, Italy, Switzerland and Spain is for covered warrants on domestic underlyings. This has changed from two years ago. At the same time, we have seen a shift of interest from single stock warrants to index warrants.” He adds that volatile stock markets have polarised demand in Europe. In Germany, for example, some investors have moved to products even riskier than plain vanilla call/put structures in the form of turbos, while others prefer risk-defensive products like guaranteed, structured or discount certificates. (Turbo warrants have stop loss points rather than maturity dates. As soon as the value of the underlying asset hits this point, the covered warrant closes.) Product differentiation Mr Klatt attributes Citigroup’s success to its broad product range and innovation, such as offering two different turbo types. “We are always striving to increase our product range to meet customer demand and expectation. Customer service and education, such as roadshows, seminars, newsletters, etc. is also key.” Despite being the largest covered warrants issuer in the world, Citigroup has not offered products in the UK. Mr Klatt said they made a decision not to be among the first wave of issuers in the UK, but are “keeping a close eye on the market for the time being”. GianLuigi Pedemonte, senior vice- president of market management Europe at TradingLab, the Milan-based subsidiary of Italy’s Unicredito bank, says a specialist desk of covered warrants market makers is essential to keeping spreads tight. “Spreads on the most liquid stock can vary between issuers by as much as 1.5 to 2.5 per cent,” says Mr Pedemonte. “Investors should check the spreads between bid and offer prices.” “It is important for investors to know that the issuer can maintain liquidity because if they cannot find a price, they cannot close their position. Investors use covered warrants to profit from strong movements in prices. They need to know the market maker can always provide a price and liquidity. Our website provides real time prices for investors and simulated scenarios for movements in prices,” Mr Pedemonte adds. At JPMorgan, Toby Peters, head of equity derivatives marketing, says the bank tries to differentiate its covered warrants through the most “aggressive stock and index quotes.” To tighten spreads, JPMorgan focuses on the most liquid assets and provides large quotes on both bid and offer as market maker. “What differentiates issuers of covered warrants is whether they can maintain these tight spreads over time,” says Mr Peters. Demand may have fallen over the past two years, as with all stock market-related investments, but covered warrants are still a core product for private investors in continental Europe. The addition of ever-more sophisticated products, such as oil and gold, enables investors to continue to try to profit from volatility in all markets, not just stock markets.

Distinguishing features While covered warrants are similar to financial options, there are some notable differences:

• Covered warrants are issued by investment banks and listed on stock exchanges, which means they can be bought through stockbrokers. They have a set lifespan from the moment they are issued.
• When buying a covered warrant, an investor is given the right to buy or sell an asset, usually a share, index, currency or commodity, at a specific price during the lifespan of the product.
• Rather than buying the underlying asset, the covered warrant gives the right to buy it at a fraction of its actual price. By having to invest only a fraction of the actual price of an asset, an investor can put the rest of the money in a bank account and earn interest.