Basic notions of Covered Warrants – Part One

They are referred to increasingly more often, over three thousand of them are listed on Borsa Italiana; yet many people are still not perfectly familiar with the working, terms of use and advantages offered by this instrument.

What are Covered Warrants

A Covered Warrant incorporates, in the form of a freely transferable security, the right to buy or sell a certain underlying at a fixed price (strike price) within a set period (“American” style), or on the established expiry date (“European” style). They are called derivative instruments, since they “derive” their value from the trend in the price of an underlying asset, normally shares, indices, currencies, commodities, etc. They can be admitted to trading only if issued by companies subject to prudential supervision by the Bank of Italy and, therefore, essentially by banks. Covered Warrants are listed and traded on Borsa Italiana S.p.A.’s dedicated market, SeDeX.

When to use them

One of the principal aims of Covered Warrants is to draw maximum benefit from short-term movements in the underlying, hence predominantly for trading purposes. According to the anticipated price movements of the financial instrument’s reference asset, two types of Covered Warrants are purchased: a Call Covered Warrant is purchased where a rise in the price of the underlying is expected, and a Put Covered Warrant is purchased where, on the other hand, there is expected to be a Fall in the price of the underlying. It is important to always bear in mind the higher level of risk to which ownership of a Covered Warrant exposes the investor with respect to direct investment for example in shares: in fact, the value of the Covered Warrant always amplifies the price fluctuations of the asset to which it is linked (so-called leverage effect); this value may even cancel out completely on expiry if the price movements in the underlying are not in keeping with the investors forecasts. Against the potential higher earnings to be obtained, the risks of a loss are therefore amplified. Here again, there is no getting away from the rule that defines the relationship between risk and yield ratio as directly proportional.

Covered Warrants can be used not only for purely speculative purposes but also to protect the value of individual shares or a securities portfolio.  For example, if a general decline is expected in the prices of shares held in portfolio, a way of hedging against this risk is to buy a Put Covered Warrant on the market index: should the negative trend in share prices in fact occur, the instrument in question will acquire value, thus offsetting the losses recorded by the portfolio.

Lastly, careful attention should be given to another two aspects: the underlying’s volatility factor and the effect of the passage of time (so-called “time decay” factor).  If the underlying is very volatile and the expiry of the Covered Warrant is a long way off, there is a greater possibility that the instrument in question, whether call or put, may have a positive settlement value at maturity (“in the money”).  Hence high volatility and a remote expiry date, all other variables being equal, imply payment of a higher purchase price for the Covered Warrant.  Consequently, it is possible that, given the same value of the underlying, the Covered Warrant may lose value following a drop in the underlying’s volatility expectations or simply due to the passing of days to maturity.

Advantages of Covered Warrants

• Possibility to obtain high profits: a Covered Warrant theoretically has unlimited appreciation potential.  Against the possibility of a high profit, an investment in Covered Warrants implies assuming an equally significant risk: the maximum potential loss corresponds to the entire capital invested;
• Strong reactivity to market movements: the value of a Covered Warrant generally varies more than proportionally upon changes in the value of the reference underlying due to the financial leverage phenomenon;
• Call Covered Warrants can be used as an alternative to direct investment in the underlying.  To take a bull position on a share, instead of buying the share directly, it is possible to invest just a part of the capital in a call Covered Warrant on the chosen share and allocate the remaining amount to alternative investments.

Covered Warrant definitions

• At the Money: definition of a covered warrant where the current value of the underlying is exactly equal to the strike price;
• Call: right to purchase;
• In the money: definition of a call covered warrant where the current value of the underlying is higher than the strike price, and put covered warrant where the current value of the underlying is lower than the strike price;
• Multiple: quantity of underlyings controlled by a single covered warrant;
• Out of the money: definition of a call covered warrant where the value of the underlying is lower than the strike price, and put covered warrant where the value of the underlying is higher than the strike price;
• Premium: price payable to acquire a covered warrant;
• Put: right to sell;
• SeDeX: the certificates and covered warrants market;
• Strike Price: price at which the right to purchase (call) or sell (put) can be exercised;
• Underlying: underlying asset;
• Intrinsic value: value realisable in case of immediate exercise;
• Time value: the probability that the value of the underlying will rise;
• Volatility: measurement of the intensity of the underlying asset’s price fluctuations.