Covered Warrants are a category of securitised derivatives listed on the SeDeX that are characterised by the presence of leverage effect.
Instruments with leverage effect allow investors the opportunity to participate in the performance of the underlying asset to an extent that is more than proportional to the changes in the underlying, and in so doing to enhance the potential yield of their portfolio.
This is the mechanism whereby investors – through a derivative – are able to control a certain underlying by investing just a small part of the capital needed to acquire possession thereof.
In this way, whenever a change occurs in the value of the underlying, the percentage variations of an instrument with leverage effect are greater than those pertaining to a direct investment in the underlying. These instruments are suitable for experienced investors who understand their working mechanisms and who use them to make targeted investments in underlyings that are expected to generate a profit.
Easy to access, simple to use
Covered Warrants can be easily purchased and sold, just like shares, at any time during the continuous trading phase of the SeDeX market.It is therefore quick and easy for investors to constantly monitor their investments. Investments in covered warrants can be made even for very small amounts and without the need to apply the margin deposit payment system. In the event of a gain, a small sum invested in any case offers the possibility to obtain a high performance, while the maximum loss is limited to the initial investment.
What are they?
Covered Warrants are securitised options which assign to the buyer the right, but not the obligation, to purchase (Call CW) or sell (Put CW) at a pre-established price (strike price) a certain underlying financial asset prior to (American style) or on the expiry date (European style), against payment of a premium.
While Covered Warrants do not normally assign to the investor the right to delivery of the underlying asset, they recognise the payment of a spread, if positive, between the value of the underlying and the strike price (Call CW) or between the strike price and the value of the underlying (Put CW).
Call Covered Warrants
Call Covered Warrants are suitable instruments for investors with bullish expectations on the underlying. They in fact offer increasing earnings potential provided that the value of the underlying asset continues its upward trend.
How they work
Investors generally choose a Covered Warrant on an underlying asset with which they associate a potential rise. These instruments recognize the investor's right to receive the intrinsic value, namely the spread between the market price of the underlying asset and the Covered Warrant's strike price. However, the buyer of a Call Covered Warrant realises a net profit only from the moment when the intrinsic value exceeds the premium paid to purchase the instrument. At the time of exercise, the settlement price is equal to either zero or the following value, whichever is higher:
(Reference Price of Underlying – Strike Price) x Multiple where multiple is used to indicate the quantity of underlying controlled by each Covered Warrant.
It is immediately clear that since the maximum losses are equal to the premium paid, the earnings potential for the investor is in theory unlimited and generally increases in proportion to the rise in the underlying.
Put Covered Warrants
Put Covered Warrants are suitable instruments for investors with bearish expectations on the underlying. They in fact offer increasing earnings potential provided that the value of the underlying asset continues its downward trend.
How they work
Contrary to what happens with Call Covered Warrants, investors generally choose a Put Covered Warrant on an underlying asset which is expected to follow a negative trend, a bearish movement. Put Covered Warrants recognise the investor's right to receive the differential between the strike price and the market price of the underlying asset.
The buyer of a Put Covered Warrant therefore "monetises" the intrinsic value if at maturity the level of the underlying is below the strike level, but only realises a net profit from the moment when the intrinsic value exceeds the premium paid to purchase the instrument. It is worth mentioning that a Put Covered Warrant is an important hedging instrument as part of a well-diversified portfolio.
At the time of exercise, the settlement price is equal to either zero or the following value,whichever is higher:
(Strike Price - Reference Price of Underlying) x Multiple where multiple is used to indicate the quantity of underlying controlled by each Covered Warrant.
In the case of a put covered warrant, as shown in the pay-off chart, the potential profit is limited since the value of the underlying asset can never be negative whereas the maximum loss corresponds to the premium paid at the time of purchase.