How do Covered Warrants work

a) Backing a share or asset you think will rise in the future

Investors who believe that a particular share is going to rise in price in the future can buy a call warrant.

Instead of paying the full amount for a share, which you would have to do if you bought it normally on the market, buying a Covered Warrant allows you to back the share by putting up a fraction of the price.

If the underlying share price goes up, the value of the call warrant will also rise.

A simple example:

Say for example Vodafone's current share price is £1.

Then lets say you have the chance to buy the underlying share at £1. Or alternatively you can buy a Vodafone £1.20 December 2003 call warrant for say 10p. This warrant gives you the right to buy Vodafone shares at £1.20 up to December.

If Vodafone's share price rose to £1.50 by December and you had bought the underlying share you would make a 50% profit on your outlay.

However, if you had bought a warrant for 10p, its value on expiry would be 30p (£1.50 minus the exercise price of £1.20) and the return on your outlay would be 200%.

b) Backing a share or asset you think will fall in the future

Investors who believe that a particular share is going to fall in price in the future can buy a put warrant.

If the underlying share price goes down, the value of the put warrant will also rise.

A simple example:

Say for example Vodafone's current share price is £1.

Then let’s say you have the chance to sell the underlying share at £1. Or alternatively you can buy a Vodafone 80p December put warrant for say 10p. This gives you the right to sell Vodafone shares at 80p up to December.

Now if Vodafone's share price fell to 60p by December and you had sold your shareholding and bought it back you would have made 40% profit.

However, if you had bought a put warrant for 10p, its value on expiry would be 20p (80p minus the exercise price of 60p) and the return on your outlay would be 100%.

But of course in both examples if the underlying share price had moved in the wrong direction you could have lost up to 100% of your investment.