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Trading the FTSE with warrants

Created:

17 February 2010

Written by:

Glenn Martin

When you've got a strong idea about where the FTSE is headed over the next couple of months, covered warrants are a great way of turning your view into big returns.

One way you can come up with strong covered-warrant trading ideas for the FTSE 100 is to use the ShareMaestro system. ShareMaestro is a computer model that identifies when the FTSE is either cheap or dear based on fundamental and economic factors. It has a very strong record of identifying longer-term buying and selling opportunities, but also works over shorter horizons.

Here's a simple example of what you can do. Whenever ShareMaestro's valuation of the market is at least 105 per cent of its actual price - suggesting upside - you buy a FTSE 100 call warrant. The warrant to choose would be the one whose exercise price is nearest to 80 per cent of the present market price.

So, if the market is at 5000, you'd ideally buy a warrant with an exercise price of 4000, and with an expiry date in three to six months' time. On that basis, the time value should form a very small percentage of the warrant price and that the gearing multiple should be at least 4 times.

You then hold this warrant for two months and sell it as soon as the ShareMaestro valuation for the FTSE 100 falls below 105 per cent of its actual price. Then buy it again if the valuation rises back above 105 per cent. If the valuation doesn't fall below 105 per cent, you hold the warrant until expiry.

While you cannot lose more than your initial stake with a covered warrant, it is still wise to cut your losses sometimes. With the ShareMaestro strategy, you should sell your call warrant if its price drops by 25 per cent. Having sold, you should then wait until the warrant expires before attempting to buy another when the market becomes undervalued.

Risk controls are vital because sometimes panic can drive a cheap price even cheaper. Although over time the underlying price will revert to fair value, it may do so too late - after the expiry of the warrant.

How it's performed

Although equity covered warrants have only been available since 2002, option pricing models such Black-Scholes generate prices which are very close to actual warrant prices. It is therefore possible to calculate historic warrant prices and establish a track record for this strategy:

By employing this strategy since the birth of the FTSE 100 in 1984, there have been 30 profitable trades, with an average profit of 21.6 per cent. And there have been 10 unprofitable trades, with an average loss of 18.7 per cent. (I assume a 1 per cent bid-ask spread, but do not include brokerage commissions.) Therefore, our hit-rate is three-quarters, with an average of 1.5 trades a year.

Run your own warrant fund

You could easily use this ShareMaestro strategy to run your own trading fund by investing the proceeds of each FTSE 100 warrant sale in an interest-account pending your next purchase. The fund requires you to take a longer-term view, as there will be occasional dips after unprofitable warrant trades.

The historic performance has been spectacular. In the 10 years to 31 December 2009, such a ShareMaestro trading fund would have delivered an annual return of 20.1 per cent. The annualised return from holding the FTSE and reinvesting dividends over the same period was just 0.86 per cent.

Since 1984, the compound annual return has been 18.4 per cent. £1000 invested in 1984 within a self-invested personal pension (Sipp - had they existed throughout this period) would have grown to over £80,000 by the end of 2009.