Why should an investor in shares be interested in warrants? There are quite a few reasons, but by far the most important is the opportunity for greater price gains in a warrant than in the associated share. This feature of warrants is called gearing.
GearingGearing is found everywhere in the financial markets. If you borrow money from the bank and invest the money in the stock market, you are said to be 'gearing up' your exposure to stocks. Similarly, if you arrange a mortgage from a bank to buy a house, you are gearing up your exposure to the property market.
» Example
A good example of gearing is when a mortgage is arranged to buy a house. Let's take the example where a house price is GBP100,000, but a buyer only has GBP10,000 cash. The buyer arranges to borrow the difference - GBP90,000 – from a bank, and then buys the house. One year goes by, house prices rise 100%, and the house is sold for GBP200,000. The owner pays back the GBP90,000 borrowed to the bank (for the purposes of this example, we'll forget the relatively small interest payments). The owner is then left with GBP110,000. This is eleven times (1,000%) their starting capital of GBP10,000. Not a bad return! But the house they bought only increased in price by 100%. Hence, their total investment return was far greater than the increase in price of the asset they bought. This magnification of investment return is called gearing.
| Initial price of house | 100,000 |
| Initial cash | 10,000 |
| Size of mortgage | 90,000 |
| One year later, house sold for | 200,000 |
| Money repaid to bank | 90,000 |
| Residual cash | 110,000 |
| Investment return on 10,000 cash | 1,000% |
| Increase in house price | 100% |
There are risks associated with gearing, which we will go into later, but in a rising market the gearing associated with warrants means that investment in them is usually far more profitable than investing in the associated shares.
This can best be demonstrated by way of an example.
» Example
The chart below shows the price performance of the TR Property shares and warrants over the period Dec 95 – Jan 01. The scale for the share price is given on the left axis, while that for the warrant is on the right.
As can be seen from this chart, there is a degree of correlation between the two securities: generally, when the share rises, the warrant rises as well, and vice versa.
However, by plotting the share and warrant on two separate scales, we do not get a sense of the relative magnitude of the respective price moves. For example, over the period, Jan 00 – Jan 01, TR Property shares rose from about 40p to 60p (an increase of 50%). But over the same period, the warrants rose from about 4.5p to 13.5p (an increase of 200%). Therefore, an investment in the warrants would have yielded four times that gained on the share.
The relative performance of shares and warrants can be better illustrated using a chart where the prices of both securities are re-based to 100, as shown below.
Inspection of the chart above displays again the close correlation between the shares and warrants, but illustrates far better the effect of gearing at work. The warrant price can be seen to mirror, but exaggerate, the movements of the share price.
The actual closing prices on two specific dates in this period for the shares and warrants are given in the table below.
| TR Property shares | TR Property warrants | |
|---|---|---|
| Price: 17 Feb 2000 | 40.30p | 4.50p |
| Price: 12 Jan 2001 | 60.30p | 13.30p |
| Increase (%) | 49.6% | 195.6% |
The major attraction of warrants therefore is this feature of gearing - they track, but magnify, the share price movements. In bull markets, 'smart money' will often flow into warrants, instead of shares, to gain from the turbo-charged performance of warrants.
Indeed, in bull markets, warrants will easily outperform most shares, and tables of greatest price increases among all securities will always be dominated by warrants at the top.
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