Covered Warrants I

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16. Basic analysis I (underlying asset)

You should always know exactly what you are buying, how it is valued, and what the potential profits or losses might be. All this needs is a basic understanding of some basic terms and concepts which will enable some of the principal calculations to be made. These allow for a simple comparison between competing warrants, and help to avoid expensive mistakes by steering you towards those warrants with better risk/reward ratios and prospects for capital growth.

Fundamental Analysis

Before buying any warrant you need to take a view on the likely direction of an underlying asset. Although there are several influences which have a bearing on warrant prices, the movement of the underlying asset is usually the most powerful. But this in itself is not enough.

If the analysis points to a rising share price, for example, it is possible there may a wide range of call warrants to serve this purpose. But is it better buy a short-dated, highly-geared, out-of-the-money warrant or a more conservative medium-term warrant with modest gearing and some intrinsic value? Do you invest a lot or a little?

To answer these questions requires some deeper thought and some more detailed steps to develop a clearer expectation for the future movement of the asset price. The judgement might be broken down into four parameters – direction, degree of confidence, size of movement, and likely time-frame.

1. Direction. The most important influence on a warrant price.
2. Degree of confidence. It is very useful to measure the degree of confidence you might have in any judgement because this can materially affect the selection of the most appropriate warrants. For example, alow degree of confidence might lead you towards in-the-money warrants with modest gearing levels.
3. Size of movement. If your analysis can quantify this so that you can reach a definite expectation, then your warrant choice can be tailored more effectively to maximise returns. Investors expecting a small movement in an asset which might generate a satisfactory rather than enormous profit will not want to take too much risk, so an in-the-money warrant with moderate gearing might be suitable.
4. Likely time-frame. The final question is over what period the movement is likely to occur. Whilst a long-dated warrant provides maximum leeway and opportunity for a move to occur, greater profits will be generated by shorter-dated warrants if the move happens quickly.

Chart Analysis

Chart analysis, or technical analysis, lends itself quite well to the study of covered warrants. Many investors are looking for short-term opportunities in the warrants market, perhaps even day-trading, and charts can be of considerable help in identifying market resistance levels and turning points, finding overbought or oversold stocks, following momentum, plotting trendlines, setting target prices, and generally in timing buying and selling decisions.

Tempting though it might be to plot individual graphs for warrants in which you are interested, it will normally be of more use and greater relevance to stick with the underlying asset.

Having applied fundamental and chart analysis to form a judgement on an underlying asset, the next step is to look for suitable warrants.

1. Introduction 2. What are covered warrants? 3. Comparison between corporate warrants and covered warrants 4. Advantages of warrants 5. Advantages of warrants – the magic of gearing 6. Disadvantages of warrants 7. Advantages & disadvantages - a summary 8. International warrants markets 9. UK warrant market 10. Types of covered warrant I (warrant terms) 11. Types of covered warrant II (underlying assets) 12. Types of covered warrant III (exotics) 13. Information on warrant terms 14. Warrant trading 15. Warrant pricing 16. Basic analysis I (underlying asset) 17. Basic analysis II (prices and terms) 18. Basic analysis III (gearing) 19. Basic analysis IV (intrinsic value) 20. Basic analysis V (premium) 21. Advanced analysis I (Black-Scholes Model) 22. Advanced analysis II (volatility) 23. Advanced analysis III (the greeks) 24. Risk 25. Trading strategies 26. Tax 27. Conclusion

• Andrew McHattie on Covered Warrants