The biggest appeal of warrant trading lies in the leverage effect. Investors only need to invest a small sum to earn a potential return or even higher than that from directly investing in the underlying. However, in picking warrant, investors often get confused with gearing and effective gearing. So, what are the differences between them? Which of them is more indicative?
Effective Gearing = Gearing * Delta
Relationship between maturity and effective gearing
Maturity is negatively related to effective gearing. If we have two warrants with the same strike price but different maturity dates, the one with a longer maturity has a lower effective gearing than the other. This is because that the one with a shorter maturity has a lower time value, and thus a higher effective gearing.
ITM/OTM and effective gearing
Further OTM warrants have a higher effective gearing, because their gearing levels are higher. So, if we have two call warrants with the same maturity but different strike prices, the further OTM one will have a higher effective gearing.
By now, most readers must have understood that one should look to the effective gearing to predict the size of change in the warrant price for every 1% change in the underlying price.
Yet, one should note that effective gearing can only reflect the theoretical change in the warrant price in response to a given amount of change in the underlying price in the near term. In fact, when the underlying price changes, the delta and gearing levels will change to, which in turn affect the effective gearing. Besides, the formula for effective gearing is based on the assumption that all other things being equal (such as implied volatility, interest rate and market supply and demand). Hence, in case these factors vary, the warrant price may fail to rise in the way suggested by the effective gearing even in the short term.
In general, premium and effective gearing go up and down together. So, a low-premium warrant has a low effective gearing, and the same goes for the opposite. In the case of a short term ITM warrant, although it carries a high delta, its effective gearing is low due to the high price tag and thus, a low gearing. Mind you, warrant trading is mainly about the leverage effect. When the effective gearing is too low, it does not mean much to invest in the warrant, which only gives you a slightly enlarged return when the underlying price moves. Yet, you are not facing less risk associated with the shortening maturity and changes in implied volatility. The risk and return are out of proportion. Besides, although such warrants have a low premium, they are not suitable for investors with a short term perspective. For a more appropriate strategy, you should first identify your target underlying and short list the relevant warrants with a comfortable effective gearing. Then, simply compare the candidates based on their implied volatility to select your right warrant.