Leverage is one of the main reasons you would invest in warrants. Generally, warrants cost only a fraction of the price of the underlying asset, offering higher percentage returns (positive and negative) when compared with the underlying asset.
To demonstrate the effect of leverage, you can compare investing in a share to investing in a call warrant. Both give you exposure to the price movement of the underlying share. With a call warrant, however, you only pay a fraction of the underlying share price for the same exposure.
XYZ shares are currently trading at $20.00. A call warrant gives you the right, but not the obligation, to purchase XYZ shares for $20.00 from the warrant issuer. The warrant price is $0.73. If the share price rises to $21.00 on the same day and you could sell the warrant $1.38.
|XYZ shares||XYZ warrants|
|Return on investment (%)||5%||85%|
The absolute increase in the value of the warrant is less than the increase in the value of the shares ($0.65 compared to $1.00). The percentage return on the warrant, however, is higher (85% compared to 5% for the shares). This is due to the significantly lower amount you had to pay for the warrant, compared to the cost of the underlying share.
Leverage always works both ways. If the share price falls to $18.00 at expiry of the warrant, the warrant would expire worthless. While you would only lose 10% on the share, you would have lost 100% of your investment in the warrant.
Leverage can also be expressed in numerical terms, and represents the number of warrants (adjusted by the conversion ratio) that can be bought for the same price as one underlying share. The higher the number, the greater the leverage of a warrant.
Leverage = (current share price / (warrant price x conversion ratio)
This simplistic formula assumes that warrant has a delta of one. For a more refined approach, visit our online warrants class in the “Pricing of warrants” section or go straight to the knowledge bank item “gearing” and “elasticity”.