Traditional equity investors may not be familiar with the term gearing, even though they have probably used it to make a large financial commitment.
The majority of UK adults have. If you have a mortgage on a home, and perhaps a second property as well, then you have geared exposure to the UK property market. For an initial deposit of perhaps £10,000, or perhaps nothing at all, you were able to borrow the rest – for a price – and thereby gain access, and the financial exposure, to an asset worth far more.
In the warrants market, gearing is calculated very simply by dividing the asset price by the effective warrant price (ie the warrant price multiplied by the cover ratio):
| Gearing = | asset price |
 | |
| (warrant price x cover ratio) |
Example
Share price 100p; warrants 25p; cover ratio 1.
| Gearing = | 100p |
| |
| (25p x 1) |
Although gearing is frequently explained and illustrated in terms of the larger profits which it can generate, it is important to note that this simple gearing calculation measures the amount of additional exposure gained by investing in the warrant, and is not a multiple for the percentage price movement.
In other words, a warrant with four times gearing will not necessarily move four times as much as the underlying asset. This would only be the case if the premium were zero; otherwise the declining premium will eat into the actual leverage.
Watch out because gearing, leverage, and elasticity are all used in different ways in different markets.
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