Gearing is the primary attraction of warrants. Because of this, we spend some time in this section looking at gearing in more detail.
More for less. Its an attractive proposition, and this is what gearing is all about. Warrants are pure capital securities, and the capital gains they can achieve when things go well are heady to say the least.
Buying covered warrants rather than the underlying assets directly means that you can gain access for a lower entry cost.
If some shares are 100p and a covered warrant carries the right to buy the shares at 80p, then the warrants might trade at 20p (assuming a zero premium for simplicity). A 20% rise in the shares from 100p to 120p means that the warrants must be worth at least 40p a 100% increase.
Example - Adidas-Salomon
A graphical illustration is useful. This example uses the shares of the German sporting goods company Adidas-Salomon and a DZ Bank 17/09/02 call warrant carrying the right to buy 0.1 shares at EU90 per share.
In this case the share price and warrant price seem to move very much in tandem, so where is the gearing benefit?
The answer lies in the lower price of the warrants, which is masked by the double-axes of the graph.
Looking closely at the price rally at the start of May 2002, for example, the shares rose from EU75.2 to EU88 and at the same time the warrants moved up from EU0.12 to EU0.51. Shareholders gained 17% over the fortnight, but the warrants rose by no less than 325%, magnifying this rise very significantly.
A different form of chart illustrates the gearing more dramatically.
Example - Thiel Logistik
This example is another German stock, Thiel Logistik. The chart below plots the shares of Thiel Logistik and a series of Deutsche Bank warrants which rose by 354% over the month of July 2002. In this case the shares and warrants have both been rebased at 100 at the start of the period.
The gearing benefit is obvious from this graph!
Market levels of gearing
Gearing tends to be much higher on average for covered warrants than in the traditional company and investment trust warrant market.
In July 2002 the average gearing in the traditional London market stood at three times, whereas a study of 180 over-the-counter covered warrants at the same time found average gearing of 15 times. This might be why the top corporate warrant over the month posted a rise of 44%, whereas some Exane Peugeot 46.4 8/02 covered put warrants accelerated by 245%.
High levels of gearing are available from covered warrants, which means potentially high excitement and high returns.Recommend Reading