Some have asked how they can make up for lost time, meaning they wish they had found the precious metals when silver was below $10 and gold was under $600. Certainly we cannot turn back the hands of time, yet we thought this month we would visit one of the more conservative ways to gain leverage – [long term warrants].
So writes David Morgan (www.silver-investor.com) in edited excerpts from his latest The Morgan Report (Volume 15; Issue 7; July 2013) on the topic of warrants entitled Gaining Leverage – A Conservative Approach?
[The following article is presented by Lorimer Wilson, editor of www.munKNEE.com and has been edited ([ ]), abridged (…) and/or reformatted (some sub-titles and bold/italics emphases) for the sake of clarity and brevity to ensure a fast and easy read. This paragraph must be included in any article re-posting to avoid copyright infringement.]
Morgan goes on to say in further edited excerpts or paraphrased commentary:
Although we’ve discussed share purchase warrants in the past, we are revisiting this topic and going into greater detail in terms of approaching them from both a qualitative and quantitative aspect.
The qualitative is quite easy and can be simply said as follows: Look for warrants on high-quality companies. The quantitative aspect first has to do with finding warrants with a long time until expiration as well as strong leverage to the underlying stock and how to identify mispriced warrants or those with very little to no implied time value.
Finding warrants with these attributes isn’t easy to find, however, the sheer size of the warrants market makes it much easier to do so, as warrants have become increasingly less popular over the years. Similar to options, warrants give one the right but not obligation to purchase the underlying assets at a stated price (strike) until a stated date (expiration).
Typically these are sold (purchased) on a 1:1 basis, which means if you purchase one warrant you have the right to purchase one share of stock unless otherwise stated. Unlike options, a warrants expiration date varies over a longer period of time; leverage varies at different prices, and warrants also trade as equity. This is beneficial for those who trade on margin.
In the following exercises, we will demonstrate how to calculate the “potential gain” in a warrant versus a straight stock purchase, which of course is zero leverage unless you use margin in your account….
Sandstorm Gold Wt. A
The first step entails calculating the return on investment (ROI), or rate of return, on both common stock and warrants at one or more specified projections of common stock price at expiration…
[If we were of the opinion that it was realistic to expect that the common stock of Sandstorm Gold, for example, would double from its July 5th price of $6 to $12 by the time the warrant expired on October 19th, 2015 then:
- to determine the ROI for the common stock we simply divide the $12 price projected at expiration by the current $6 stock price, i.e. $12 divided by $6 = 2 – 1.00 x 100 = 100%. No surprise there.
- to determine the ROI for the warrant based on the strike price of $5.28Cdn ($5.00US) at expiration would yield us a minimum value of $6.72 ($12/share – $5.28 strike price/share = $6.72) which, divided by the current price of the warrant ($2.30 as of July 5th), equals an ROI of 192.17% ($6.72 divided by $2.30 = 2.92 – 1.00 x 100).
- to calculate how much leverage the warrant has, assuming a $12 stock price on or before expiry on Oct. 19th, 2015, we then just divide the ROI of the warrant (192%) by the ROI of the common share (100%). The leverage of Sandstorm Gold A warrants is calculated to be 1.92. This means that for every $1 increase in the stock price, the warrant would appreciate $1.92 or 92% (1.92x) more based on the July 5th prices for the common stock and the A warrant.
Now that’s leverage! The only caveat here is that the common stock must rise to $12 on or before the warrant expires on October 19th, 2015 to realize this return. A lesser price appreciation in the stock would mean a lesser return. For example, a 66.7% increase in the current $6/share price to $10/share price on or before Oct. 19/15 would only generate leverage of 1.05x for the warrant. Bottom line. The Sandstorm Gold warrant A is not worth the risk if you are not confident that the associated common stock will not appreciate by at least 66.6% before the warrant expires.]
The warrant investor needs to be aware that owning the stock outright is the conservative approach. When using the warrant, the basic common stock MUST appreciate to a certain level BEFORE the warrant’s risk/reward basis becomes better than an outright stock purchase…
New Gold Wt. A
[Now let’s do the same calculation on New Gold warrant A which expires on June 28th, 2017) and is currently out of the money and therefore has more leverage than the Sandstorm Gold warrant A analyzed above.
In the case of New Gold let’s assume that the common stock will triple in price from its current $7 (July 5th) price to $21 given the fact the warrant does not expire for another 4 years.
- To determine the ROI for the common stock we simply divide the $21 price projected at expiration by the current $7 stock price, i.e. $21 divided by $7 = 3 – 1.00 x 100 = 200%. No surprise there.
- To determine the ROI for the warrant based on the strike price of $15 at expiration would yield us a minimum value of $6 ($21/share – $15 strike price/share = $6) which, divided by the current price of the warrant ($1.27 as of July 5th), equals an ROI of 372% ($6 divided by $1.27 = 4.72 – 1.00 x 100).
- To calculate how much leverage the warrant has, assuming a $21 stock price on or before expiry on June 28th, 2017, we then just divide the ROI of the warrant (372%) by the ROI of the common share (200%). The leverage of the New Gold A warrants is calculated to be 1.86. This means that for every $1 increase in the stock price, the warrant would appreciate $1.86 or 86% (1.86x) more based on the July 5th prices for the common stock and the A warrant.
A lesser price appreciation in the stock would mean a lesser return. Were the stock only to reach $20 on or before the June 28th 2017 expiry of the warrant the leverage of the warrant would be 1.58, 1.26 at $19 and .86 at $18. Conversely, stock appreciation beyond $21/share would realize outsized leverage for the warrants (at a $25 stock price the warrant leverage would be 2.67!)
Bottom line. At this point in time it would appear that the New Gold warrant A is not worth buying if you are not confident that the associated common stock will appreciate in price to at least $20. Were it to do so you would enjoy a 58% premium for having taken the risk.
As outlined above,] the benefit to buying out of the money warrants is that once you surpass [a certain point], leverage accelerates quickly. Ideally the higher you expect the share price to go on or before expiry, the more attractive these warrants become….
When using any type of leverage, even warrants, the key is timing—these types of opportunities are present rarely. We know that the divergence in gold to gold shares is at a 30 year low, meaning the value of gold shares is at a once in a generation situation, yet we still see slippage. Now is a good time to apply warrants, and the exercise we provide could be useful to you. Our time horizon has changed over the years so picking a time of many years out is most likely the best, unless a particular option is badly mispriced.
Final note: No matter how we explain the process there will be some who “don’t get it.” If that is the case then either forget using warrants altogether…[or consider subscribing to a service provided by Dudley Baker – www.preciousmetalswarrants.com and www.commonstockwarrants.com – where all the leverage calculations necessary to make an informed decision are done for you.]
[Editor’s Note: The author’s views and conclusions in the above article are unaltered and no personal comments have been included to maintain the integrity of the original post. Furthermore, the views, conclusions and any recommendations offered in this article are not to be construed as an endorsement of such by the editor.]
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