What are Covered Warrants?

A covered warrant is a special kind of option. An option gives you the right to buy or sell something at a certain price by a certain date. Covered warrants are a type of equity option, which means they’re an option to buy shares of a company’s stock.

Here’s the key thing about covered warrants – they’re issued by banks or other financial institutions, not by the company itself. The bank that issues the covered warrant already owns the underlying shares. So when you exercise your covered warrant, you get existing shares rather than newly issued shares.

Another important thing to know is that covered warrants are long-dated options. That means they usually last for 3-5 years before expiring. That’s a lot longer than your typical stock option!

Since covered warrants are issued by third-party banks, the company whose shares are involved doesn’t need to approve them. The warrants are “covered” by the bank’s existing shareholdings, so no new shares need to be issued. That’s why they’re called non-dilutive.

How do you actually use a covered warrant?

Let’s say you buy a covered warrant from BigBank that allows you to purchase shares of CoolCompany for $50 each, and it expires in 4 years. You paid $5 for each warrant.

For the next 4 years, you have the right to “exercise” that warrant. That means you give BigBank your $50 per share, and they give you existing CoolCompany shares in return. The shares come from BigBank’s own holdings.

If CoolCompany shares go up above $50 during those 4 years, your warrants become “in-the-money.” That’s good for you, because you can exercise them and get the shares for less than the current trading price.

But if CoolCompany shares stay below $50, your warrants are “out-of-the-money.” If you held them till expiration, they’d be worthless and you’d lose the $5 per warrant you paid up front.

Of course, you don’t have to hold till expiration. Covered warrants themselves also trade on exchanges. So you could sell your warrants to another investor before they expire.

Why would investors use covered warrants?

Covered warrants provide leverage. A warrant might cost $5 initially to control a $50 stock. If that stock went up 20% to $60, your $5 warrant might be worth $10, a 100% gain. Of course leverage amplifies both gains and losses.

Warrants also have a longer time horizon than standard stock options. More time equals more potential for the underlying stock to move in your favor.

Some people like warrants because they know their exercise won’t dilute the underlying stock. The shares are coming from the bank, not newly issued from the company.

What’s in it for the banks who issue them?

Issuing banks usually charge an up-front premium to sell the covered warrants. Then they use the proceeds to buy the underlying stock as a hedge.

The bank hopes that many warrants will expire unexercised and out-of-the-money. In that case, they keep the initial premium and don’t have to hand over any shares.

Banks also hope to profit from the bid-ask spreads in warrant trading. And they can lend out their underlying shareholdings for additional revenue.

Covered warrants are interesting because they’re a bit exotic. They’re not super common in all markets. But they’ve been pretty popular in places like Europe and Asia.

Some real-life covered warrant examples

Let’s look at a couple real covered warrants to make this more concrete.

Back in 2019, JPMorgan issued covered warrants tied to Alibaba shares. They were 5-year warrants exercisable at a strike price of $250 per Alibaba share.

In 2018, Société Générale issued 3-year covered warrants linked to Apple shares. Those ones had a strike price of $225 per Apple share.

Each of these covered warrants gave investors a leveraged upside bet on the underlying stocks over a multi-year time frame. Of course, leverage can cut both ways if the stocks don’t cooperate.