Banks devise new structures that bet on the markets

Hundreds of new exchange traded derivative products have been launched this week, to meet a growing demand from private investors who want to speculate on markets but limit their risk.

On Monday, Société Générale (SG), one of the pioneers of listed retail derivatives in the UK, announced the issue of 61 new covered warrants linked to the FTSE 100 and 250 indices and to the prices of commodities such as crude oil, platinum and silver.

Then, on Friday, the bank issued a further 143 – on a range of underlying stock-market sectors, including Mining, Energy and Utilities, and on individual shares, such as Lloyds TSB, Prudential and Shell. At the same time, it broadened its new range of listed contracts for difference (CFDs), known as Turbos, by issuing contracts on shares such as Barclays, BP and Vodafone.

Royal Bank of Scotland (RBS) launched its own range of covered warrants for private investors three weeks ago, with 100 different products linked to the performance of large-cap UK stocks, international equity indices and commodities.

All of these products allow private investors to trade movements in the prices of the underlying assets with different levels of gearing – to magnify their potential profits. But, because they are quoted securities, losses are limited to the amount invested. In this way, they differ from spread bets and conventional CFDs, which can incur losses greater than the amount staked by a trader – resulting in a “margin call” for more money to cover a losing trade.

“We are seeing more and more people saying ‘I switched to warrants because I want to sleep at night,’” explains Isabelle Braly-Cartillier, head of marketing for structured and listed products at SG. “They were shifting from traditional spread bets and CFDs. That’s why we decided to launch the Turbos range, which are between covered warrants and CFDs. We really saw a demand for that.”

David Lake, head of listed products sales at RBS, says the UK bank’s move into covered warrants is intended to meet a similar demand. “In times of such market uncertainty we aim to provide investors with the tools they may need to help control their portfolio.”

Covered warrants were first listed on the London Stock Exchange in 2002, and work in a similar way to options.

“Call” warrants give private investors the right, but not the obligation, to buy an underlying share, index or commodity at a predetermined price, known as the strike price, on or before a certain date in the future, known as the expiry date. So a call warrant will rise in value when the underlying asset rises in price – but, as the warrant only costs a fraction of the asset price, its price will move proportionately more, providing a geared return (see box above). If, instead, the price falls, the warrant will expire worthless – but all that is lost is the price of the warrant, limiting the loss.

“Put” warrants do the opposite, giving private investors the right to sell and potentially make a geared return from price falls.

Listed CFDs, such as SG’s new Turbos, work in a similar way, in that they have a strike price, an expiry date and can provide gearing.

But they can provide more gearing than covered warrants and have a different kind of downside protection, called a “knockout barrier”. When the price of the underlying asset hits the barrier, the contract automatically expires, limiting the loss to no more than the amount invested. There may even be a small redemption value.

“Turbos were launched back in September and trading volumes have increased since then,” says Alexandre Chessé, head of listed product sales, UK. “Their main difference is high gearing. For example, T129 on the FTSE 100 has gearing of 7.3 times.”

However, most UK traders still prefer to use spread bets for geared trading, as their profits are not taxable. “We tend to do a very modest amount of covered warrants business,” says Alex Orban, VP of UK Securities at online broker E*Trade.

“Our ratio of covered warrant trades to spread bets is in the low single digits. If you want to undertake this kind of trading, but don’t want to deal with tax, spread betting is the way to go. We tend to have customers who are more self-directed and more comfortable doing the risk management themselves.”

Spread betting providers argue that their products are easier to understand, as their prices mirror the price of assets in the market. By contrast, warrants and Turbos are priced like options, and take into account the intrinsic value of the option, and the time value.

“Lack of clarity in pricing is an issue for me,” says Gary Thompson, head of sales trading, at CMC Markets. “You’re paying for a Glaxo 1125p Turbo with a strike of 925p and the price is 209.3p. I just can’t work out how they get to 209.3.”

He also suggests that the knockout barrier on Turbos can be effectively replicated using a free non-guaranteed stop-loss with a spread bet or CFD. “The advantages of Turbos are the same as CFDs and spread betting but without the clarity of pricing.”