What Is a Covered Warrant?
A warrant is a type of investment security that gives the holder the right, but not obligation, to buy or sell an underlying asset at a specified price on or before a specified date. The covered warrant is a type of warrant where the issuer is a financial institution rather than an individual company. Covered warrants can have single stocks, baskets of stocks (as in sectors or themes), indexes, commodities, or currencies as their underlying assets.
Understanding Covered Warrants
Covered warrants are listed on major international exchanges in London, Hong Kong, and Singapore. The warrant is "covered"' because when the issuer (a financial institution) sells a warrant to an investor, it will usually hedge (cover) its exposure by buying the underlying asset in the market. A regular warrant, on the other hand, is issued by the company that also issued the underlying shares.
- Warrants are like options because the contracts represent the right, but not the obligation, to buy or sell an underlying asset.
- Covered warrants are different than standard warrants because financial institutions (rather than the individual company that also issued the underlying shares) create the contracts.
- Like listed options, covered warrants come in two types: put warrants and call warrants.
- Covered warrants can only be purchased; contracts can not be sold or "written" like stock options.
- An investor might buy a call warrant when the price of the underlying security is expected to increase and a put warrant when there are fears about a market decline.
A covered warrant bears many similarities to an option. It gives the investor the right to buy an underlying asset, like a call option (call warrant), or sell, like a put option (put warrant). Each warrant has a strike price and expiration date. Additionally, both covered warrants and options are composed of intrinsic value and time value. However, some aspects set them apart.
A covered warrant can be either European style or American style, the former indicating that exercise of the right can only occur on the expiration date, and the latter signifying that an investor can exercise the right anytime between purchase date and expiration date.
Also, options can be "written." For example, when writing a call option, the investor is selling a call, which obligates them to deliver shares at a set price on a specified date to the buyer if that buyer exercises the call. On the other hand, writing a put is selling a put option, which will obligate the seller to buy shares if the buyer of the put exercises the right to sell at a set strike price.
By contrast, a covered warrant can only be purchased. Another difference between a covered warrant and option is that the typical life of a covered warrant is six to nine months, whereas options can have expiration terms ranging from one week to two years.
Example of Covered Warrant
The FTSE 100 Index is a benchmark for 100 of the leading names with shares on the London Stock Exchange. It has among the most popular covered warrants. An investor might buy call warrants when they expect stocks in the U.K. to advance or buy put warrants when concerned that prices will fall.
Another example of a strategy using covered warrants is called stock replacement or cash extraction. Say, for example, that the FTSE 100 Index has advanced considerably over the past 12 months and a portfolio manager holding a basket of similar stocks is concerned about a market decline. However, they also want to participate if the market advances further. In this scenario, a strategy might be to sell their shares and invest some of the cash into FTSE 100 call warrants. Holding the warrants allows the portfolio manager to book gains if the market advances further, but with less capital than holding the underlying shares of the FTSE 100. If the market does not advance, however, the premium paid for the warrants will likely be lost.