Why do warrants tend to be more volatile than the mother shares? Are they more volatile at certain periods of their life span?
The number one advantage of warrants is ‘gearing’. Warrants give investors exposure to an underlying share for a fraction of its cost. This means that a warrant investor is effectively ‘exposed’ to a much larger holding of stock through buying the warrant than they would be if they purchased the underlying share directly with the same amount of capital. For this reason, warrants tend to increase and decrease in greater percentage movements than their underlying shares.
"Effective gearing" is one of the most useful ratios for investors who are wanting to approximate how a warrant will increase/decrease in response to a move in the underlying share. Effective gearing is expressed as a number and will usually range from 2 to 10 times for most Singapore warrants. Effective gearing estimates the amount of increased exposure that a warrant holder will gain by buying the warrant as opposed to the underlying share. For example, if an investor bought $10,000 worth of a call warrant over ABC shares and the warrant has an effective gearing of 5.0 times, they would have an effective exposure of approximately $50,000 (5 x $10,000) worth of ABC shares.
Effective gearing can also be used to estimate the percentage move that a warrant should make for a corresponding move in the underlying share. Take an example of a call warrant over XYZ shares where the warrant has an effective gearing of 3.5 times. If the underlying share increases by 1% the warrant should increase by approximately 3.5% (3.5 x 1%). Be aware however that effective gearing is an estimate only and assumes no change in other factors, such as volatility or time decay, that can effect the price of the warrant. Effective gearing will also change as the share price changes, so it is only accurate over small movements in the underlying share.
The answer to the second part of the question is “Yes”, warrants will tend to be more responsive (or volatile) at different periods of their life span. Generally speaking, a warrant will have a lower effective gearing at the start of its life and this will tend to increase (all other things being equal) as it gets closer to its expiry date. It follows therefore that short dated warrants will usually be more responsive (or volatile) than similar longer dated warrants. Therefore, short dated warrants may provide an advantage for aggressive short-term investors as they will be achieving a larger exposure for their capital invested. However, for the same reason, shorter dated warrants carry more risk than their long dated equivalents. It follows then that conservative or longer term investors may prefer to buy longer dated warrants than their intended holding period. Although these longer dated warrants may not rise as fast as a shorter dated warrant when the share price rises, they may also not fall as fast when the share price falls. Longer dated warrants may also hold their value better over time as they do not decay as fast as shorter dated warrants. Investors should consider their own appetite for risk and their investment profile when selecting a warrant.
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