Generally, covered warrants are not instruments for long-term investment. They are tools with which you can pursue specific investment strategies. Without exploring this topic in a comprehensive way, it is worth a look at three main strategic categories – speculation, hedging, and cash extraction.
Speculation
If the experience in other overseas markets is replicated, and it probably will be, then the bulk of activity in UK covered warrants will be short-term trading by investors seeking to make quick profits. Some issuers said that a surprisingly high proportion of investors trading in its warrants consisted of day trading, and that the average holding period for its warrants was just a few weeks.
Using covered warrants for speculative purposes means taking advantage of their gearing in an aggressive way.
Traders will usually be looking for high historical volatility, deltas and leverage, and probably a short time until expiry. Warrants with these characteristics offer plenty of potential for action, although this comes with a commensurately high risk.
Hedging
For private investors, hedging is probably more of a theoretical possibility than a common usage. Most investors take a view and back it. Or if things go wrong they accept the loss. On occasions though it can make sense to hedge a portfolio, where you wish to protect it, for example, against the possibility of a market fall but do not wish to sell your holdings for tax reasons. Covered warrants can be used effectively in this role where they are available.
Delta neutral hedging
The delta can be used in a simple way to estimate hedging requirements. If an investor has a shareholding and wishes to buy the correct number of warrants to hedge the position – to cancel out any gains or losses – then the right quantity can be calculated using the delta:
| Number of warrants required = | number of shares |
 | |
| delta |
To hedge an existing portfolio, put warrants need to be used.
Example
If an investor has 10,000 shares, and a put warrant exists with a delta of 0.4, the investor would need to buy (10,000/0.4) = 25,000 of the warrants to create a delta neutral hedge position. If the shares were to fall in value by 50p, creating a loss on the shares of £5000, the put warrants would increase in value by 50p multiplied by the delta of 0.4, so 20p each. With 25,000 warrants the gain works out at £5000, exactly cancelling out the loss on the shares.
Note: because the delta changes, this is a fragile balance which requires periodic adjustment, or rebalancing.
Cash Extraction
In risky, nervous, unpredictable markets, the cash-extraction approach to warrants can make very good sense. It is often overlooked.
Casual observers tend to focus on the more obvious and exciting trading applications without realising that warrants can be applied to a portfolio to reduce risk and to fulfil a defensive strategy. Gearing can be interpreted defensively to keep a toe in the water without getting a soaking if markets move the wrong way.
Rather than gearing up and investing the same amount by buying more warrants, investors can gear down and obtain the same exposure to the underlying assets for less money, releasing the balance for other use and reducing the maximum possible loss.
The number of warrants which should be bought to maintain the same profit potential as that from a shareholding can be calculated using the same formula as used for the delta hedge, except that it now relates to call warrants:
| Number of warrants required = | number of shares |
| |
| delta |
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