What are covered warrants and how do they work?

In recent years, the financial market has seen growing interest in derivative instruments that combine flexibility and return potential. Among these, covered warrants represent a particularly versatile solution, appreciated by both retail investors and industry professionals. These instruments allow access to hedging or speculation strategies with limited capital, but they are not without complexity.

To make the most of them, it is essential to understand their structure, operation and associated risks. In this article, we will delve into covered warrants, examining what they are, how they work and what advantages they can offer.

What are covered warrants: let’s give a definition

To understand what covered warrants are, let’s start with a comprehensive definition:

covered warrants are derivative financial instruments that incorporate the right to buy (call) or sell (put) an underlying financial asset at a certain price (strike or exercise price) on a specific date or within a certain period of time.

This instrument is issued by a financial institution and is distinguished from standard options by a fundamental characteristic: covering, i.e. the coverage of the obligation by the issuer. In other words, the issuing institution guarantees the availability of the underlying or equivalent coverage.

The underlying can vary significantly, including shares, market indices, currencies or raw materials. This variety allows investors to diversify their portfolio and access different markets without having to directly purchase the underlying asset.

In fact, thanks to the mechanism of financial leverage intrinsic in their construction, covered warrants (cw) are very popular instruments among traders who use them mainly for trading purposes, that is, they try to operate on the short and very short movements of the underlying financial asset, benefiting from the leverage effect that allows them to amplify the oscillations of the underlying itself. However, this financial leverage amplifies not only potential gains, but also losses, making the instrument suitable for expert or risk-aware investors.

Types of covered warrants

We have seen that covered warrants are a particular category of derivative financial instrument that can be traded on a regulated stock exchange. The definition of "derivative" is given because these products derive their price from another underlying asset, be it a stock index, one or more stocks, raw materials, currency exchanges.

There are two versions of covered warrants, distinguished by the type of right that the investor assumes when trading them:

• covered warrant calls give the buyer the right to purchase an underlying financial asset at a certain price (strike or exercise price);
• covered warrant puts give the buyer the right to sell an underlying financial asset at a certain price (strike or exercise price).

Another variable that differentiates the different types of covered warrants is the final observation date of the right, whether it is a call or a put. If this can be exercised by the investor on a specific date, for example at maturity, the cw is said to be European style; if the right can be exercised within a certain period of time, the product is said to be American style.

Covered warrant call
For covered warrant call, if the value of the underlying is greater than the strike price, the instrument is said to be “in the money”. If an investor exercises a covered warrant call that is "in the money" he will obtain a profit calculated with this formula:

• (value of the underlying - Strike price) / (parity x exchange rate) – premium
  If, however, the value of the underlying is lower than the strike price of the cw, the product is said to be “out of the money”, that is, its exercise would cause a loss to the investor who holds it.

When the value of the underlying and the strike price coincide, the covered warrant is said to be “at the money” and its exercise is neutral for the investor.

Covered warrant put
In the case of covered warrant put, if the value of the underlying is lower than the strike price, the instrument is said to be “in the money” and the investor will benefit from a profit calculated in this way:

• (Strike Price - value of the underlying) / (parity x exchange rate) – premium

If, on the other hand, the value of the underlying is greater than the strike price, the cw is said to be “out of the money” and the investor who exercises it will lose an amount equal to the premium paid for the purchase of the instrument.

As in the case of a covered warrant call, when the value of the underlying and the strike price coincide, the covered warrant is said to be “at the money” and its exercise is neutral for the investor.

How Covered Warrants Work and What Determines Value

Covered warrants work on a combination of market dynamics and contractual specifications defined by the issuer. When you buy a covered warrant, you obtain a contractual right on the underlying that you can exercise under certain conditions.

The value of a covered warrant is based on five factors:

• the price of the underlying;
• the volatility of the underlying;
• the time remaining until expiry;
• the risk-free interest rate;
• the expected dividends.

When one of these factors changes, the price of the instrument changes. To understand the extent of the change, you will need to look at the so-called Greeks, which are indicators of the sensitivity of the covered warrant price to the parameters mentioned above. Here are the main "Greeks" to consider when evaluating a covered warrant:

Covered warrant and underlying price (Delta)

The movements of the price of the financial asset with respect to the exercise price inevitably influence the value of a covered warrant. For this reason, it is important to evaluate how and by how much the price of the underlying moves with respect to the strike price. The Greek Delta indicates, all other market factors being equal, how much the price of the covered warrant varies when the value of the underlying varies by one unit.

The Delta is a number between 0 and 1 for calls and between 0 and –1 for puts and expresses the probability that the covered warrant will end up “in the money” at maturity. Consequently, the covered warrant whose price of the underlying asset is very close to the strike (so-called “at the money”) has a Delta very close to 0.5, the “deep out of the money” one has a delta close to 0, the “deep in the money” one has a delta very close to 1.

Covered warrants and the time effect (Theta)

The passage of time has a negative effect on the value of a covered warrant. This effect is called “time decay” (time decay) and is summarized by the variable Theta. If the expiration of a covered warrant is far in the future, the probability that the instrument, whether call or put, may have a positive liquidation amount (in the money) at maturity is greater.

Therefore, as the days pass, the price of a covered warrant, all other things being equal, decreases due to the effect of "time decay" which reduces the probability of obtaining a profit.

Covered warrants and interest rates (Rho)

The value of a covered warrant also changes with the variation of risk-free market interest rates. The Rho variable indicates the ways in which the value of the covered warrant varies with respect to the variation of interest rates and therefore of the cost of financing. This parameter is in absolute value much lower than Delta and Vega.

Covered warrants and dividends (Phi)

The price of a covered warrant also changes due to the effect of the dividends distributed by the underlying stock or index. The Greek variable Phi indicates how the value of the covered warrant varies with respect to the variation of the expectations relating to the detachment of dividends that the underlying will operate during the life of the covered warrant. The same consideration applies, in relation to the value of the parameter, made for Rho.

Covered warrant and volatility (Vega)

The volatility of the underlying financial asset has a proportionately direct effect on the covered warrant. If the underlying is very volatile, the probability that the instrument, whether call or put, may have a positive liquidation amount (in the money) at maturity is greater. These probabilities are summarized in the variable Vega.

Therefore, high volatility, all other things being equal, implies a higher price to pay for the purchase of a covered warrant. Consequently, it may happen that, with the same value of the underlying, the covered warrant loses value in correspondence with a decrease in the volatility expectations of the underlying.

The Vega graph has a bell shape, with the peak corresponding to a value of the underlying close to the strike (“at the money”). This parameter is always positive, but takes on a value close to zero if the covered is “deep in the money” or “deep out of the money”.

The operational purposes of covered warrants

As we have observed, being financial instruments traded on regulated stock exchanges, covered warrants lend themselves to online trading, consistently with the price movement expectations of the asset to which the financial instrument refers.

The operational purposes of a covered warrant, therefore, can be of two matrices: bullish or bearish. In the face of bullish expectations on a given underlying asset, the investor will focus on a Covered Warrant Call; in the face of expectations of a fall in the price of the underlying asset, the investor positions himself on a Covered Warrant Put.

Let’s now delve into two of the most interesting aspects of covered warrants, namely the leverage effect and the possibility of using them for hedging purposes of a portfolio of multiple assets.

Covered warrants and leverage effect

Thanks to the leverage effect incorporated in covered warrants, the performance of the underlying financial asset can differ significantly from that of the instrument. In fact, the value of the covered warrant amplifies the price fluctuations of the asset to which it is linked. In the face of the possibility of obtaining greater gains, the risks of losses are therefore amplified.

Covered warrants and portfolio coverage

Covered warrants can be used to build effective portfolio coverage strategies. In essence, with cw puts the investor can hedge against the risk of new declines in assets already present in the portfolio in such a way as to compensate for the losses resulting from the declines in the underlying asset that he previously held.

In fact, if the negative trend in the prices of the shares in the portfolio occurs, the instrument in question will acquire value by compensating for the losses recorded by the other assets.

Covered warrants: key terms for understanding the investment

When an investor is evaluating whether and possibly which covered warrants to purchase, the terms to which he must pay particular attention before proceeding with the purchase or sale are the following.

Generic terminology of derivative financial instruments

• ISIN: or the alphanumeric code that uniquely identifies a financial asset;
• Instrument type: i.e. whether a Call or Put covered warrant;
• Listing market: i.e. the market where the financial instrument is listed;
• Expiry: i.e. the day on which the issuer makes the final recording of the value of the underlying and, based on the resulting pay-off, liquidates the investors who still hold the covered warrant in their portfolio;
• Last trading day: i.e. the last day on which the CW can be freely traded on the market where the instrument is listed;
• Underlying: i.e. the financial asset that determines the price, and therefore the performance, of the covered warrant;
• Strike level: i.e. the exercise price of the covered warrant with which the current value of the underlying must be compared to determine the value of the instrument;
• Multiple: quantity of the underlying controlled by a single covered warrant;
• Parity: quantity of covered warrants required to purchase one unit of the underlying;
• Financial leverage: i.e. the multiplier of the positive or negative performances of the underlying applied to the prices of the covered warrant;

Technical terminology relating to covered warrants and options

• At the Money: definition of the covered warrant whose underlying financial asset is quoted at a current value exactly equal to the strike;
• Call: right to purchase the underlying financial asset;
• Deep in the money: definition of the covered warrant call with a current value of the underlying much higher than the strike, and of the covered warrant put with a current value of the underlying much lower than the strike;
• Deep out of the money: definition of the covered warrant call with a value of the underlying much lower than the strike, and of the covered warrant put with a value of the underlying much higher than the strike;
• In the money: definition of a covered warrant call whose underlying financial asset is quoted at a current value higher than the strike, and of a covered warrant put whose financial asset is quoted at a current value lower than the strike;
• Out of the money: definition of a covered warrant call whose underlying financial asset is quoted at a value lower than the strike, and of a covered warrant put whose underlying financial asset is quoted at a value higher than the strike;
• Premium: price to be paid to purchase a covered warrant, whether it is a call or a put;
• Put: right to sell the underlying financial asset;
• Strike Price: price at which it is possible to exercise the right to buy (call) or sell (put);
• Underlying: underlying financial asset. It can be an index, a share, a raw material or a currency;
• Intrinsic value: value realisable in the event of immediate exercise;
• Time Value: probability that the value of the underlying asset will increase;
• Volatility: measurement of the intensity of price fluctuations of the underlying asset.

Original article published on Money.it Italy. Original title: Cosa sono i covered warrant e come funzionano