Traditional corporate equity warrants

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16. Dealing in warrants

Around 250 equity warrants have a full listing on the LSE, and can be traded in exactly the same way as ordinary shares.

It is not necessary to set up a special trading account with a broker; but a formality requires a Risk Warning notice to be signed. (This affirms that you understand the risks associated with warrants).

You don't need to invest a lot of money in warrants. Quite the opposite. As explained in greater detail below, liquidity is an issue with warrants, that usually precludes large investments in warrants. Given general commission levels, the minimum practical amount to invest in warrants is around £750; while trade sizes of £2,000 and above will be more efficient.

Execution-only or advisory stockbrokers?

In recent years, the trend has been towards using cheap, execution-only brokers. And these can certainly be used to trade warrants. However, in the case of warrants, there are some arguments for using an old-style advisory stockbroker.

Dealing in the warrant market is not exactly similar to dealing in the share market. The warrant market is far from efficient, and suffers from problems of liquidity. An experienced warrants broker will know what an acceptable spread is, and may have some idea of the position of the market maker's book. This key knowledge may allow him to deal 'inside' the quoted price. A good broker can further warn an investor of poor liquidity, or alert them to new issues and trading opportunities.

These practical benefits of dealing through a specialist warrants broker are important, and can outweigh any small differences in dealing charges. Of course, not all stockbrokers understand warrants. In fact many don't. It is worth spending some time on looking around for a good one.

Liquidity

As mentioned above, dealing in warrants is little different from ordinary shares. But the one significant issue can be that of poor liquidity. This is reflected in the low volume of warrants traded (turnover), which itself influences the size of the bid-offer spread. These two factors are discussed below.

Turnover

The normal daily turnover in warrants can be very low: averaging between zero and just a few thousand warrants traded. This partly reflects the fact that not many investors follow warrants, and also that the total number of warrants issued is very small. At October 2001, the market capitalisation of the whole warrant market was below £1bn, and the market cap. of the average single warrant issue was just £2m.

Such low turnover has a number of ramifications, including wide bid-offer spreads and small dealing sizes. The latter leads to -

1. If a warrant has a price of 50p and an average daily volume of 2,000, this means that an investor wanting to invest £10,000 in the warrant, will have a problem, as a total of just £1,000 of warrants trades each day. As such, it may take the investor some time to build a large position in the warrant, and - importantly - they will not be able to sell quickly.
2. Not only do the small dealing sizes lead to problems in building, and closing out, large positions; they also lead to significant sensitivity in the warrant price when trading. Buying even small quantities of the warrant can result very quickly in the price moving up against you, And vice versa, when selling.

Because of the small dealing sizes and the consequent sensitivity of prices, when trading warrants it is always a good idea to use limit - not market - orders. It is often wise to use limit orders when trading shares, but doubly so for warrants.

Bid-offer spread

A consequence of low turnover, is wide bid-offer spreads on warrants. The table below displays the spreads on an ordinary trading day for a sample of warrants.

As can be seen, the spreads range from around 5% to 30% - which is fairly representative for the whole warrant market. The spread percentage is calculated on the offer price, and so represents the amount a purchased warrant needs to increase - just to cover the cost of the spread! The size of these spreads is far wider than one finds in the shares market, and are, by any normal measures, outrageous. However, it must be said that they are a fairly honest reflection of the poor liquidity in the market, rather than merely the result of greedy pricing by market makers.

The wide spreads on warrants are offset to some extent by the fact that commissions are charged on just the sterling value of a trade, even though a warrant trade gives exposure to a far greater value of shares due to the gearing.

The poor liquidity in warrants - especially the wide spreads -mean that warrants are not very suitable for short-term trading. But the disadvantages of poor liquidity diminish somewhat for longer-term holdings.

Liquidity is poor, however...

Being aware of the problems above, many investors decide that warrants are to be avoided. Which is completely understandable. However, for others, willing to sail in the backwaters, opportunities can be found, that just don't' exist in the more efficient shares market. For example, a share price can rise, but it may take some time for its associated warrant to react.

Warrants can also be particularly suitable for individual investors, who are free to dip in and out of the warrant market - a market all but closed to institutional investors due to its small size.

Warrant funds - alternatives to direct dealing

As described above, the inefficiencies of the warrant market can offer up opportunities not found in more efficient markets. However, it does require work to find the opportunities. And for many investors, they will not have the time to devote to this niche area. For them, it may be better to invest in one of the new warrant funds that have recently been set up.

1. Introduction 2. What is a warrant? 3. The warrant market 4. Advantages of warrants over shares - the magic of gearing 5. Further attractions of warrants 6. Disadvantages of warrants 7. Fundamentals - warrant terms 8. Fundamentals - intrinsic value and parity ratio 9. Basic analysis 10. Analysis - time value and premium 11. Analysis - gearing 12. Analysis - break-even and capital fulcrum point 13. Analysis -sample spreadsheets 14. Analysis - summary 15. Investing strategies 16. Dealing in warrants 17. Warrant exercise 18. Further topics 19. Further information 20. Conclusion

• Andrew McHattie on Covered Warrants