Appendix 6
FSA derivatives
and warrants
risk warning
Warrants and derivatives risk warning notice (E)
E
Table This table belongs to COB 5.4.6 E.
This notice is provided to you, as a private customer, in compliance with
the rules of the Financial Services Authority (FSA). Private customers are
afforded greater protections under these rules than other customers are
and you should ensure that your firm tells you what this will mean to you.
This notice cannot disclose all the risks and other significant aspects of
warrants* and/or derivative* products such as futures*, options*, and
contracts for differences* (* delete as appropriate). You should not deal in
these products unless you understand their nature and the extent of your
exposure to risk. You should also be satisfied that the product is suitable
for you in the light of your circumstances and financial position. Certain
strategies, such as a ‘spread’ position or a ‘straddle’, may be as risky as a
simple ‘long’ or ‘short’ position.
Although warrants and/or derivative instruments can be utilised for
the management of investment risk, some of these products are unsuit-
able for many investors. Different instruments involve different levels
of exposure to risk and in deciding whether to trade in such instru-
ments you should be aware of the following points. (Include or delete as
appropriate).
238 FSA derivatives and warrants risk warning
1. Warrants
A warrant is a time-limited right to subscribe for shares, debentures,
loan stock or government securities and is exercisable against the origi-
nal issuer of the underlying securities. A relatively small movement in
the price of the underlying security results in a disproportionately large
movement, unfavourable or favourable, in the price of the warrant. The
prices of warrants can therefore be volatile.
It is essential for anyone who is considering purchasing warrants to
understand that the right to subscribe which a warrant confers is invari-
ably limited in time with the consequence that if the investor fails to
exercise this right within the predetermined time-scale then the invest-
ment becomes worthless.
You should not buy a warrant unless you are prepared to sustain a total
loss of the money you have invested plus any commission or other trans-
action charges.
2. Off-exchange warrant transactions
Transactions in off-exchange warrants may involve greater risk than deal-
ing in exchange traded warrants because there is no exchange market
through which to liquidate your position, or to assess the value of the war-
rant or the exposure to risk. Bid and offer prices need not be quoted, and
even where they are, they will be established by dealers in these instru-
ments and consequently it may be difficult to establish what is a fair price.
Your firm must make it clear to you if you are entering into an off-
exchange transaction and advise you of any risks involved.
3. Securitised derivatives
These instruments may give you [a time-limited right (Note 1)] [an absolute
right (Note 2)] to acquire or sell one or more types of investment which is
normally exercisable against someone other than the issuer of that invest-
ment. Or they may give you rights under a contract for differences which
allow for speculation on fluctuations in the value of the property of any
description or an index, such as the FTSE 100 index. In both cases, the
investment or property may be referred to as the ‘underlying instrument’.
These instruments often involve a high degree of gearing or leverage, so
that a relatively small movement in the price of the underlying investment
results in a much larger movement, unfavourable or favourable, in the
price of the instrument. The price of these instruments can therefore be
volatile.
These instruments have a limited life, and may (unless there is some
form of guaranteed return to the amount you are investing in the prod-
uct) expire worthless if the underlying instrument does not perform as
expected.
FSA derivatives and warrants risk warning 239
You should only buy this product if you are prepared to sustain a [total
loss (Note 3)] [substantial loss (Note 4)] [loss (Note 5)] of the money you
have invested plus any commission or other transaction charges.
You should consider carefully whether or not this product is suitable for
you in light of your circumstances and financial position, and if in any
doubt please seek professional advice.
Notes (these notes are not part of the notice):
1. Use for instruments such as covered warrants where there is some form of exercise
required by the investor.
2. Use for instruments such as linked notes, or some certificates where there is no form of
exercise required by the investor.
3. Use for instruments such as covered warrants where the return payable to the investor is
totally dependant upon the performance of the underlying instrument/s to which the product
is linked and there is not another form of payment due to the investor (for example the repay-
ment of capital).
4. Use for instruments such as linked notes where there is a form of return paid to the
investor irrespective of the performance of the underlying instrument/s to which the product
is linked, but the return is low.
5. Use for instruments such as linked notes where there is a form of return paid to the investor
irrespective of the performance of the underlying instrument/s to which the product is linked,
but the return is high but less than 100 per cent of the amount paid for the product.
4. Futures
Transactions in futures involve the obligation to make, or to take, delivery
of the underlying asset of the contract at a future date, or in some cases
to settle the position with cash. They carry a high degree of risk. The
‘gearing’ or ‘leverage’ often obtainable in futures trading means that a
small deposit or down payment can lead to large losses as well as gains. It
also means that a relatively small movement can lead to a proportionately
much larger movement in the value of your investment, and this can work
against you as well as for you. Futures transactions have a contingent
liability, and you should be aware of the implications of this, in particular
the margining requirements, which are set out in paragraph 9.
5. Options
There are many different types of options with different characteristics
subject to the following conditions.
Buying options:
Buying options involves less risk than selling options because, if the
price of the underlying asset moves against you, you can simply allow the
option to lapse. The maximum loss is limited to the premium, plus any
commission or other transaction charges. However, if you buy a call
option on a futures contract and you later exercise the option, you will
acquire the future. This will expose you to the risks described under
‘futures’ and ‘contingent liability investment transactions’.
240 FSA derivatives and warrants risk warning
Writing options:
If you write an option, the risk involved is considerably greater than buy-
ing options. You may be liable for margin to maintain your position and a
loss may be sustained well in excess of the premium received. By writing
an option, you accept a legal obligation to purchase or sell the underlying
asset if the option is exercised against you, however far the market price
has moved away from the exercise price. If you already own the underly-
ing asset which you have contracted to sell (when the options will be
known as ‘covered call options’) the risk is reduced. If you do not own the
underlying asset (‘uncovered call options’) the risk can be unlimited. Only
experienced persons should contemplate writing uncovered options, and
then only after securing full details of the applicable conditions and
potential risk exposure.
Traditional options:
Certain London Stock Exchange member firms under special exchange
rules write a particular type of option called a ‘traditional option’. These
may involve greater risk than other options. Two-way prices are not usu-
ally quoted and there is no exchange market on which to close out an
open position or to effect an equal and opposite transaction to reverse an
open position. It may be difficult to assess its value or for the seller of
such an option to manage his exposure to risk.
Certain options markets operate on a margined basis, under which buy-
ers do not pay the full premium on their option at the time they purchase
it. In this situation you may subsequently be called upon to pay margin
on the option up to the level of your premium. If you fail to do so as
required, your position may be closed or liquidated in the same way as a
futures position.
6. Contracts for differences
Futures and options contracts can also be referred to as contracts for dif-
ferences. These can be options and futures on the FTSE 100 index or any
other index, as well as currency and interest rate swaps. However, unlike
other futures and options, these contracts can only be settled in cash.
Investing in a contract for differences carries the same risks as investing
in a future or an option and you should be aware of these as set out in
paragraphs 4 and 5 respectively. Transactions in contracts for differences
may also have a contingent liability and you should be aware of the
implications of this as set out in paragraph 9.
7. Off-exchange transactions in derivatives
It may not always be apparent whether or not a particular derivative is
arranged on exchange or in an off-exchange derivative transaction. Your
firm must make it clear to you if you are entering into an off-exchange
derivative transaction.
FSA derivatives and warrants risk warning 241
While some off-exchange markets are highly liquid, transactions in off-
exchange or ‘non transferable’ derivatives may involve greater risk than
investing in on-exchange derivatives because there is no exchange mar-
ket on which to close out an open position. It may be impossible to liqui-
date an existing position, to assess the value of the position arising from
an off-exchange transaction or to assess the exposure to risk. Bid prices
and offer prices need not be quoted, and, even where they are, they will
be established by dealers in these instruments and consequently it may
be difficult to establish what is a fair price.
8. Foreign markets
Foreign markets will involve different risks from the UK markets. In some
cases the risks will be greater. On request, your firm must provide an
explanation of the relevant risks and protections (if any) which will operate
in any foreign markets, including the extent to which it will accept liability
for any default of a foreign firm through whom it deals. The potential for
profit or loss from transactions on foreign markets or in foreign denomi-
nated contracts will be affected by fluctuations in foreign exchange rates.
9. Contingent liability investment transactions
Contingent liability investment transactions, which are margined, require
you to make a series of payments against the purchase price, instead of
paying the whole purchase price immediately.
If you trade in futures contracts for differences or sell options, you may
sustain a total loss of the margin you deposit with your firm to estab-
lish or maintain a position. If the market moves against you, you may
be called upon to pay substantial additional margin at short notice to
maintain the position. If you fail to do so within the time required, your
position may be liquidated at a loss and you will be responsible for the
resulting deficit. Even if a transaction is not margined, it may still
carry an obligation to make further payments in certain circumstances
over and above any amount paid when you entered the contract.
Save as specifically provided by the FSA, your firm may only carry out
margined or contingent liability transactions with or for you if they are
traded on or under the rules of a recognised or designated investment
exchange. Contingent liability investment transactions which are not so
traded may expose you to substantially greater risks.
10. Limited liability transactions
Before entering into a limited liability transaction, you should obtain
from your firm or the firm with whom you are dealing a formal written
statement confirming that the extent of your loss liability on each trans-
action will be limited to an amount agreed by you before you enter into
the transaction.
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