Call covered warrant case study

A call covered warrant gives the investor the potential to benefit from an increase in the value of the underlying asset, while limiting potential losses to the premium paid.

For all covered warrant investments, the investor can easily calculate the ‘’break-even’’ of the investment. This is the underlying price level that needs to be reached at maturity, to allow the investor to make profit.

• Call Break-even = Strike price + (Premium x Parity)
• Put Break-even = Strike price - (Premium x Parity)

 

Example of a call covered warrant

An investor has a bullish view on the FTSE 100 index over the next 4 months, so buys 10,000 call covered warrants on the index for a Premium of £2,000 (20p * 10,000).

Thus, the investor has exposure to the shares included in the FTSE 100, but without the expense of having to individually buy all the shares.

• Strike: 5,500
• Maturity: 6 months
• Premium: 20p
• Parity: 1000/1
• Quantity: 10,000
• Current level of the FTSE 100 index: 5,100

 

At maturity

Option 1: The level of the FTSE 100 index is ≥ 5,700

• The initial premium payment (£2,000) for the products is covered by the difference between the underlying level and the strike price.
• 5,700 is the ‘’break-even’’ of the covered warrant.
  If the underlying level rises beyond this, the investor will make a profit at maturity.

          5,700 = Strike price + (Premium x Parity) ie. 5,500 + (20p x 1000)

The precise amount of the payoff depends entirely upon the settlement price of the Index upon expiry of the covered warrant. Some examples of payoffs are illustrated below, together with how they are calculated:

Settlement price	Payoff	Pay off calculation (Settlement price-strike price x no of warrants/parity)	Profit	Profit calculation (Payoff-premium paid)
5,800 6,000 6,500	£3,000 £5,000 £10,000	(5,800 – 5,500) x 10,000)/1,000 = 3,000 (6,000 – 5,500) x 10,000)/1,000 = 5,000 (6,500 – 5,500) x 10,000)/1,000 =10,000	£1,000 £3,000 £8,000	£3,000 - £2,000 £5,000 - £2,000 £10,000 - £2,000

Option 2: The level of the FTSE 100 index is ≤ 5,700

• The underlying level is below the ‘’break-even’’ point, so a loss is incurred for the investor.
• If the index does not exceed the Strike level of 5,500 at maturity, the loss represents the entire initial amount invested to buy the call covered warrants:
  £2,000 = (20p * 10,000)

Should the settlement price of the Index be between 5,500 and 5,700, then there will be a payoff, but it will be less than the premium originally invested, and so the investor will make a loss. For example:

Settlement price	Payoff	Pay off calculation (Settlement price-strike price x no of warrants/parity)	Loss	Loss calculation calculation (Payoff-premium paid)
5,600	£1,000	((5,600 – 5,500) x 10,000)/1,000 = 1,000	£1,000	£1,000 - £2,000

 

The maximum the investor can lose with covered warrants is the initial capital invested.

Put covered warrant case study

A put covered warrant gives the investor the right to sell an underlying asset at a predetermined strike price at maturity for a premium.

The purchase of a put covered warrant is suitable for a strategy based on an expected decrease in the value of the underlying asset. The Put can be used for portfolio hedging or speculative investment for an underlying asset going down.

Example of a put covered warrant

An investor has a bearish view on BP over the next 3 months, so buys 1,000 put covered warrants on the share for a Premium of £470 (47p * 1,000).

• Strike: 475p
• Maturity: 10 months
• Premium: 47p
• Parity: 1/1
• Quantity: 1,000
• Current BP share price: 520p

At maturity

Option 1: The BP share price is ≤ 428p

• The initial premium payment (£470) for the products is covered by the difference between the underlying level and the strike price.
• 428p is the ‘’break-even’’ of the covered warrant.
• If the underlying level falls below this, the investor will make a profit at maturity.
  428p = Strike price - (Premium x Parity).
  = [475 - (47p x 1)]

Option 2: The BP share price is ≥ 428p

• The underlying level is above the ‘’break-even’’ point, so a loss is incurred for the investor.
• If the share price exceeds the Strike level of 475p at maturity, the loss represents the entire initial amount invested to buy the put covered warrants:
  £470 = (47p * 1,000).

The maximum the investor can lose with covered warrants is the initial capital invested.