Warrants: The key to even bigger profits from precious metals

Over the past 12 years, the price of gold has risen 546%. Over the same period the price of the HUI gold stock index has risen by 1,169%. However there is a way that investors can get even greater leverage to the rising price of gold (and silver), and that’s by holding the warrants of gold and silver mining companies rather than just the shares.

This article examines what warrants are, how they work, and which ones we have added to the 247bull investment portfolio.

What are warrants?

Warrants are securities which give the holder the right, but not the obligation, to buy the underlying shares of the issuing company. Warrants are offered at a specific price and for a specific time period after which, if they are not exercised, they will expire worthless.

Warrants are similar to other equity derivatives such as options, however there are several characteristics to which investors need to pay particular attention.

Exercising: A warrant is exercised when the holder informs the issuer of their intention to purchase the shares underlying the warrant.

Premium: A warrant’s “premium” represents how much extra you have to pay for a company’s shares when buying them via a warrant versus buying them in the regular way.

Leverage: A warrant’s leverage (often referred to as “gearing”) is the additional exposure to the underlying shares that is provided by holding a warrant as opposed to the exposure provided by the common shares.

Expiration Date: The expiration date is simply the date on which the warrants expire. Investors wishing to exercise their warrants must do so before the expiration date. The more time that remains until expiry, the more time there is for the underlying security to appreciate.

Restrictions: As with options there are different exercise types associated with warrants. In the US and Canada for example, warrants can be exercised anytime before expiration, however in Europe they can only be exercised on the expiration date.

Valuing warrants: Two key factors influence the market value of a warrant. These are its intrinsic value, and its time value. Intrinsic value is simply the difference between the exercise (strike) price and the underlying stock price. If the stock price is above the exercise price, the warrant has intrinsic value and is said to be “in-the-money”. However if the stock price is below the exercise price the warrant has no intrinsic value, it only has time value.

Time value is the value of the continuing exposure to the movement in the underlying security that the warrant provides. Time value declines as the expiry of the warrant gets closer. This so-called “time decay” increases rapidly as the expiry date approaches. It’s for this reason that I won’t consider buying warrants with less than 2 years left before expiry.

The key point is the longer the time to expiry, the greater the time value of the warrant. This is because the price of the underlying asset has a greater probability of moving in-the-money which makes the warrant more valuable.

How do warrants work?

The easiest way to explain how warrants work is with a real world example.

Let’s take New Gold, one of the companies in the 247bull investment portfolio. New Gold’s common shares currently trade on the NYSE for $11.85 under the symbol NDG, and the company has 462 million shares outstanding. However the company also has 35.6 million warrants outstanding that trade under the symbols NGD.WT.A, NGD.WT.B and NGD.WT.C.

NB: The price of a company’s warrants can be found by adding a “w” after the company’s ticker symbol.

Warrants issued under the symbol NGD.WT.A expire on 28 June 2017 and can be converted into common stock on a one-for-one basis at a cost of $15.00 per share. I.e. 1 warrant + $15.00 = 1 common share.

As this link to the Toronto Stock Exchange shows, New Gold’s warrants are currently selling for $3.45.

Therefore an investor wanting to invest $10,000 in New Gold can either buy 843 common shares, or they can buy 2,898 warrants. And because the warrants are priced at a much lower level than the stock, they provide leverage to any movement in it.

New Gold: Shares vs. warrants

Security type

Closing price 16 Oct 2009

Closing price 16 Oct 2012

Percentage gain

Shares

$4.37

$11.85

171.17%

Warrants

$0.54

$3.45

538.89%

 

As the table above shows, New Gold’s warrants have provided leverage of 3.1 to the price of the common shares and this is something that we expect to continue.

Generally speaking the leverage provided by a company’s warrants is calculated by dividing the share price by the warrant price. In the case of New Gold’s warrants that leverage factor is currently 3.4. I.e. $11.85 / $3.45 = 3.4, meaning that New Gold’s warrants should provide leverage of 3.4 to the share price.

Therefore if New Gold’s shares rise by $2.00, from $11.85 to $13.85, the shares would have provided a gain of 16.8%. However, that same $2.00 a share rise would propel the company’s warrants from $3.45 to $5.45, providing a gain of 57%.

A 3 year chart of New Gold’s warrants

A 3 year chart of New Gold’s warrants

Chart courtesy of stockcharts.com

The bottom line

During a bull market warrants provide investors with the potential for substantially bigger capital gains, and it’s for this reason that we have added New Gold’s June 2017 warrants to the 247bull investment portfolio.

It’s important to note however, that warrants can magnify losses and well as gains, and they are not suitable for every investor. The selection is also quite limited since only a small number of companies in the resource sector have issued warrants.

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