Investing in warrants can become extremely complicated. Just think about all the formulas, variables, underlying shares and so many other potential problems, all of which may eventually result in significant losses.
The first thing every investor has to realise is that investing in warrants can be hazardous to your wealth. It can very well lead to significant losses if the process is not done in the correct manner. To value warrants takes hard work and lots of calculations with a number of very complicated formulas. We are aware of this and also of the fact that not every private investor is interested in going through this tiresome process of getting to a valuation.
That`s where PSG Online comes in. We try to provide investors with the necessary information to make educated decisions with regard to warrants without actually having to make all these complicated calculations themselves. PSG Online will provide you with enough information in order to choose your warrants more carefully with the end result of reducing your potential for losses.
In this article we will not go into any detail with regard to the calculations, but only show you how to interpret the answers of the calculations we have already done. (For more in depth information with regard to these calculations refer to "Investing in Warrants" on our web site).
Warrants are transferable option certificates, which entitle the holder to buy or sell a specific number of shares in a specific company at a specific price during a specific time period. In other words, warrants are basically long-term options.
The gearing effect results in warrants offering the potential for much larger gains than shares. The gearing reflects the lower price of warrants and therefore proportionately larger absolute changes. You can achieve a large equity exposure from a relatively small investment. However, while gearing has a positive effect in rising markets, the opposite is true in falling markets. A small decline in the underlying share can lead to a substantial decline in the price of the call warrants (the opposite is true for put warrants).
Most players in the market currently use the Black Scholes model to value warrants. Even though this is a good model, we prefer not to use it, as it was originally written to price short-term options. We therefore do not consider it the appropriate method to value a warrant with more than a year to expiry.
Our preferred method of valuing warrants is known as the Pricing Analysis. This method provides you with all the necessary information with regard to the warrant, and also takes the underlying share into consideration.
Through the effective use of this model, one will automatically reduce the number of warrant which offers investment potential, as it will eliminate those warrants that are too close to expiry, as well as those that are too far out of the money.
We consider the time to expiry and the parity ratio to be the two most important factors when considering an investment in a warrant. The time to expiry simply refer to the time period remaining before the expiry date of the warrant, while the parity ratio is an indication of how close the warrant is to its strike price. We calculate the parity ratio by simply dividing the current price of the underlying share by the exercise price. A parity ratio of higher than 1 will indicate that the warrant is `in the money`, while a parity ratio of below 1 will be `out of the money`. Our general rule in this regard is not to invest in a warrant with less than one year to expiry and a parity ratio of less than 0.7. It is extremely important that an investor realise that once the warrant expires and the underlying share is trading below its strike price, the entire investment will be worth nothing. That is the reason why it is so important to make sure that the underlying share has a realistic chance of reaching its strike price before the expiry date.
Once you have chosen the warrants with a parity ratio of higher than 0.7 and time to expiry of more than a year, the following two figures will be of significant importance: Break-even and Capital Fulcrum Point. The Break-even provides the annual percentage rise required on the share price for a call warrant investor to recover the current warrant price. The Break-even point is therefore an indication of how much the underlying share price has to increase, to result in the warrant holder not losing money on the warrant.
The Capital Fulcrum Point (CFP) measures the annual percentage growth required from the underlying share for the investor to do equally well in terms of capital appreciation with either the share or the call warrant. In simpler terms: the investor will make the same amount of money by investing in either the share or the warrant. This is, however, not the reason why anyone wants to invest in a warrant. Investors want to make use of the gearing aspect offered by the warrant to get an increased equity exposure in the underlying share. What all this means, is that an investor will have to look for a warrant in which the underlying share has the potential of increasing by more than the CFP before the warrant expires. Once this happens, the investor will benefit from the gearing and generate a higher return from the warrant than from the underlying share.
By studying the following example, these points will become clear.
You will note in the table that the current share price and exercise price remains the same, we have changed the current warrant price to explain the two calculations.
With the share price at 100cps, the exercise price 120cps, the warrant price 20cps (the third example), then break-even assuming 1 year to expiry will be 40% (100 x 1.40 = 140) and the warrant will equal 20 cents at this time. Therefore if the share price appreciates by 40% per year the warrant holder will break even (not make any money). But this only leads to zero loss, the CFP in this example will be 50% (100 x 1.50 = 150). The profit made on the share price would therefore be 50%. With a share price at expiry of 150cps the value of the call warrant would be 30 cents (150 - 120). The return made from the original warrant price of 20cps would therefore also be 50%.
Summarised, if the share price grows from these levels at 40% per annum, the warrant wouldn`t lose money, if it grows between 40% and 50% per annum, the warrants would end `in the money`. However, under both scenarios it would have been better to buy the underlying share directly. It is only when the share exceeds the 50% (CFP) growth that it will have been worth your while to have invested in the warrant.
So even though you might not feel qualified to value the share these calculations will help you decide how large a risk your are taking. Where the warrant price is 5 cents and the break-even and CFP 25-26% you may decide the odds of the share growing faster than these rates are relatively good and therefore invest in the warrant. If however, the current warrant price is 40 cents it will be foolish to buy the warrant. The share price will have to appreciate by more than 100% to make it worth your while. Although not impossible, this is unlikely. And if it does grow that fast, you don`t need to invest in the warrant. A 100% return can be achieved by investing directly in the share, at much lower risk.
Once you can interpret the above calculations you can use technical analysis to time the buying or selling of the warrants. The above calculations will aid you into concentrating only on the 10%of warrants that actually have a chance to expire with a value. It therefore lowers your risk. For more detail on warrants and live calculations of the above as well as numerous other ratios, refer to the PSG Online Website.
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