CLICK TO THE MAIN PAGE ON ALL ARTICLES ON PERSONAL FINANCE 

This article deals with the following:

• Warrants and the concept of Gearing effect;
• Advantages of buying warrants instead of other instruments and
• Some strategies when buying warrants

Warrant’s unique power is pertaining to the concept of gearing. Unlike the the reduced board lots for share trading it only helps investor with the issue of affordability but does nothing on the side of gearing and heightening exposure.

If you bought 1000 shares of X and it gained RM1, your 100 shares investment of X will only provide you with a gain of 10sen which is proportionate to the amount you invested. If the former elicits a return of 10%, the latter should likewise and be no different.

Warrants and Gearing Effect:

On the other hand, if you invested in a warrant that is ten times geared (for example, warrant B is RM1 when share B is RM10), a RM1 gain in share B will likely to result in a similar gain of RM1 in warrant B if the warrant is just `at the money’ (that is, the price of share B = exercise price of warrant B). In this instance, you will find that the gearing effect of the warrant has kicked in to enable the investor to make 100% returns when the investor in the mother share has made only 10%!

Although the same gearing effects can be found when trading in financial futures, financial futures do not provide inherent downside protection like in the case of warrants. In fact, the mechanics of financial futures trading requires the maintenance and topping up of margin accounts as and when the margin level falls below the minimum required by the futures house.

Advantages of Buying Warrants:

• Warrants like stocks do not require any further capital outlay unless the warrant holder chooses to exercise the warrant on or before expiration date;
• provide excellent gearing capabilities in bullish markets;
• As it confers the right but without the obligation to acquire a fixed quantity of assets such as shares for a specified price within a limited period of time, your downside is therefore limited to the initial investment whilst you still continue to enjoy possibility of upside potential from the investment;
• Additionally, the need to only pay a small amount for the `right to ownership’ rather than ownership itself also permits the investor to leverage and increase market exposure for the same amount of capital invested;
• For a sum of less than one seventh of the market value of core component blue chips like Maybank and Tenaga, investors are able to gain the same amount of exposure to mimic and benefit from gains in the KLCI over the next four and the half years but without having to be fully exposed to the vagaries in owning these stocks per se.

• The balance capital not invested in these warrants can then be invested in fixed income securities like the all-time favourite fixed deposits and corporate bonds to provide the capital protection that most investors yearn for in today’s volatile market conditions.

Warrants and strategies:

• Invest in long dated warrants. Basically, avoid those that are close to expiry and as the element of time decay kicks in, such warrants lose their premium value quickly. In the case of short dated and `out of money’ warrants where the exercise price of the warrant is higher than the current price of the mother share, investors stand the likelihood of losing all of their capital outlay when the warrant expires worthless!

• Buy warrants that are `at or in the money’. Such warrants will experience sharp increases in their delta value for investors to enjoy hefty gains. As the delta value of the warrants captures the sensitivity of the warrant movement against the movement of the mother share, the higher the delta value the better the gearing benefit for the warrant holder. Typically, once a warrant becomes way `in the money’, the movement of the warrant will almost mirror the movement of the mother share, moving about one to one.

• Do not pay excessive premiums. The warrant premium is calculated as the ratio of the sum of the warrant and exercise price against the price of the mother share. Investors are willing to fork out such premiums for the benefit of gearing. Typically, the higher the volatility of the mother share, the higher the premium for the warrant but once this premium becomes excessive, it runs the risk of becoming over-valued.

• The higher the gearing effect, the better.

Investing in lowly geared warrants simply defeats the primary reason of investing in this instrument. Where possible, look for warrants that are at least three times geared. Gearing is simply the ratio of the mother share price to the warrant price.

• Buy as many types of warrants as possible: as we do not know which warrants price will shoot up, it’s good to buy as many different types of warrants in different industries;

• Buying warrants in a bullish market: it’s important to know that warrants works extremely well in the bullish market environment. Investors can reap benefits from its gearing effect.

• Above all, make sure we are comfortable with the fundamentals of the mother share. There is no point having a geared play on share which will fall in value rather than rise.

For any investors, it is important to understand that the gearing effect works both ways i.e. on the upside as well as on the downside!

If you found this post useful, keep updated with future posts by subscribing to FMAccounting (for free) through RSS or email.

Related Entries

• Characteristic Of Warrants And Its Technical Jargon
• Market To Book Ratio
• Bonia Proposes Main Board Transfer, 1-for-2 bonus, Share Split
• Gearing- Determinants & Its Advantages And Disadvantages
• Bonia Hits New High On Main Board Transfer