Covered Warrants I

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14. Warrant trading

Not all covered warrants in London will be traded in the same way, although to an end-user investor the difference may prove to be minimal. A limited number of warrants will use the Central Warrants Trading Service (CWTS) platform, or order book, which provides for fully-automated trading. This is a new segment on SETS, the exchange’s electronic order book. This service provides continuous execution which means that two-way prices are continuously quoted, and a broker simply executes against the bid or offer as desired. You can check the price at any time and deal instantly.

Retail Service Provision

Unfortunately the capacity on CWTS - at the moment - is limited for technical reasons. As such, it seems likely that many covered warrants will be traded outside of the CWTS order book, using Retail Service Provision (RSP) facilities. Covered warrants can be listed, but have their prices displayed through other mechanisms, and this is the function of RSPs or the RSP Gateway system which is used by stockbrokers.

This RSP system for covered warrants will not offer automatic execution, but will be a quote request system where an indicative quote may be displayed but the principal (or market-maker) is not obliged to deal until a quote is requested. In practice this should be fairly automatic, as long as the system works properly.

Normal market size

The prices quoted for covered warrants will be firm in at least the normal market size (NMS) specified by the London Stock Exchange. The NMS is specified according to the following price bands:

A rough rule of thumb is that deals of £10,000 or less will be waved through. From £10,000 upwards the principal may not necessarily be obliged to accept the deal, although in most cases it should be possible to trade in far greater size: the NMS is really just a starting point. Liquidity should not ordinarily be an issue in the covered warrants segment.

Tick size

The tick size has also been specified in advance. The tick is the smallest amount by which the price can move, and is again defined in bands.

The smallest tick size is 1/100 of the trading currency.

Exercising Warrants

Most covered warrant investors will never exercise a warrant. Whilst the value of all warrants is derived from their exercise terms, the majority of trades occur within warrants’ lives, with investors trading in and out and taking their profits or losses before the final maturity date.

Unless your aim is to buy the underlying investment, in the case of physically-settled warrants where the exercise price is paid in exchange for the asset, it will rarely be in your interests to complete the exercise notice and stump up the extra cash.

Cash Settlement

The large majority of UK covered warrants will be cash-settled rather than stock-settled. This means that the issuer will pay a cash amount for the intrinsic value of the warrants at the expiry date, or on exercise, if sooner. In other words, although the terms of call warrants are usually expressed as a right to buy, and put warrants as a right to sell, they are more accurately a right to receive a cash payment equivalent to the difference between the exercise price and the value of the underlying asset at expiry.

Example

Investor holds 5000 warrants with right to buy one share at 100p.
At final maturity date, shares close at 140p.
Cash settlement = (share price – exercise price) * number of warrants.
Cash settlement = 40p * 5000 = £2000.

Stockbroking

It remains to be seen whether it will be a simple matter to deal in covered warrants through your existing stockbroker. Few advisory stockbrokers have the expertise to embrace the market fully in its development stages – although there are exceptions – and the large execution-only stockbrokers are providing mixed support as well.

Whether you choose to deal through an execution-only stockbroker or an advisory stockbroker is a matter of personal choice. You can always have accounts with both. The choice boils down to a trade-off between cost and service.

1. Execution-only broker: some investors, particularly those dealing over the internet, prefer an impersonal approach at the lowest possible price, and if you feel confident about your ability to deal effectively without help then this makes sense.
2. Advisory broker: if you are a novice investor and would appreciate some hand-holding, or even for the broker simply to check that you are buying the series of warrants you intend, then an advisory broker can be worth the extra fees. If a canny broker well-versed in the ways of the market can prevent you from making one costly mistake, that might be enough to pay for the higher charges many times over.

Whichever style of stockbroker you use, you will have to sign a warrants risk warning notice before you can deal. This is a regulatory requirement.

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