Friday, 11 September 2015

Warrants: Effective Gearing versus Gearing

The biggest appeal of warrant trading lies in the leverage effect.

Investors only need to invest a small sum to earn a potential return close to or even higher than that from directly investing in the underlying.


Gearing only reflects how many times the underlying costs versus the warrant.  

Its calculation formula is:

Gearing = Underlying Price / (Warrant Price   x  Conversion Ratio)

Effective Gearing

However, the rate of increase/decrease in the warrant price relative to the underlying price is not the same as gearing.

To estimate the increase/decrease in the warrant price relative to the underlying price, we should look to the effective gearing.

Effective gearing reflects the relationship between changes in the warrant price and in the underlying price.

Its calculation formula is:

Effective Gearing = Gearing  x  Delta

For example, the effective gearing of a warrant is 10 times, then, other things being equal, for every 1% change in the underlying price, the warrant price will in theory move by 10%.

Put simply, delta measures how much, in theory, the warrant price will move for a $1 change in the underlying price.

When you invest in warrants, you should look to their effective gearing, not gearing, as a reference for their risk/return performance.

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