Q&A: Complex world of covered warrants

Private investors are, as of Monday, able to buy covered warrants through the London Stock Exchange.

As a result, the exchange argues, private investors will be able to play on a level playing field with fund managers and traders.

But covered warrants are high risk. Is there a danger of another mis-selling scandal?

What are covered warrants?

Put simply, in return for a premium, covered warrants allow investors the option of buying or selling a share at a fixed price at a specified later date.

If at this date the shares are more expensive than the agreed price, the investor makes a quick buck.

Why not just buy the shares?

Warrants allow investors to gain exposure to a large number of shares for a fraction of the price.

The danger is if they are marketed direct to the public then smaller investors will end up with a portfolio that is far too high risk for their needs.

Keith Sanham, director, Cripps Portfolio

This can be useful protection against falling share prices.

An investor worried that shares in a company might fall would be able to sell the stock at a set price. The drawback is the cost of the covered warrant.

Alternatively, investors believing a share is set to soar could, through a warrant, purchase the right to buy the stock at a certain price.

For a relatively small outlay, they could reap the same gains as an investor who has bought a large stock holding.

Indeed, in general, warrants are far more volatile than shares, exaggerating the price movements of the underlying stock.

So, in turn, the risks of investing in warrants are higher.

What can investors lose?

Unfortunately, investors can lose every penny of their investment.

If they call the future share price wrong, the value of the covered warrant can shrink to nothing.

For example, if a covered warrant allows the investor to buy a share at £1 but the price of the share then drops to 50p then no one will pay for the right to buy a share at double the market value.

Do covered warrants have any other purpose?

The London Stock Exchange argues that covered warrants can act as an insurance against falling share prices.

For example, an investor buying 10,000 £1 shares could buy a covered warrant that allows a further 10,000 shares to be bought at 80p in a years time.

If 11 months later the share price has fallen to 90p the investor would have lost £1,000 on the original investment.

However the covered warrant - so close to maturity - is likely to have risen in value so that potentially it covers the loss on the original investment.

Fund managers have for a long time used covered warrants to hedge their share purchases.

Nonetheless, over the past five years, when charges are factored in, the average fund manager has underperformed the FTSE All Share index.

Why is the LSE finally allowing private investors to trade in covered warrants?

Across Europe £52bn is invested in covered warrants.

And in September, the Financial Services Authority (FSA) relaxed its rules barring the marketing of covered warrants to the general public.

LSE believes covered warrants will prove popular

Six City institutions announced that they would start offering covered warrants to investors.

From 28 October, warrants will be dealt on the LSE in the same way as ordinary company shares.

Initially, the LSE said that richer investors were being targeted.

But eventually the exchange anticipates warrants appealing to the wider investing public.

However, such talk sets alarm bells ringing in an industry still coming to terms with the split capital investment trust scandal.

What alarm bells?

Keith Sanham, director of Cripps Portfolio independent financial advisory firm that manages £300m of private client investment capital, is worried by the prospect of widespread trading in covered warrants.

"It's dangerous territory, investors can really loose their shirts with this type of investment," he told BBC News Online.

As a result, Mr Sanham argues that only investors with portfolios in excess of £500,000 should consider covered warrants.

"The danger is if they are marketed direct to the public then smaller investors will end up with a portfolio that is far too high risk for their needs," he adds.

In addition, Mr Sanham is worried that all but the most financially aware private investors may struggle with the technicalities of covered warrants.

A concern the FSA may share.

Last week, FSA managing director Carol Sergeant was reported in The Times as having told a conference: "It is hard to overestimate financial illiteracy among consumers."