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Tuesday, November 25, 2008

Gold Warrants

Gold warrants are another way people sometimes like to invest in gold. However there are some important issues to be aware of before putting ones toe in the precarious world of gold warrants.

What is a Warrant

Very basically a warrant is a financial instrument* that entitles the holder of the warrant to buy stock in the company that issued the warrant at a specific price.

Simply stated, a warrant is a type of option (also known as a derivative. A ‘derivative’ is an investment product whose price is derived from another.). Many investors are familiar with exchange traded options being 'call' options and 'put' options. A Warrant is a privately issued (and not necessarily exchange traded) option.

The key advantage of Warrants is they can be issued with as many different features and benefit as the issuer or the customer requires. In gold warrants, a gold derivative is an investment product that offers price exposure to gold, but does not deal in actual physical gold. It is a speculation on the price of gold either rising or falling.

There are two types of warrants. Call Warrants and Put Warrants

Call Warrants
A call warrant is the right to buy a share at a predetermined price.

Let's assume you want to invest in Goldilocks Mining. Goldilocks Mining shares are currently $10, which you expect to appreciate to, for example, $15. This would give you a profit of $5. Of course, if you are wrong and the share price falls to $7, you would lose $3.

This is where warrants come in. Instead of buying shares directly, instead you can buy a share through a Call Warrant on the Goldilocks Mining share. This might cost $0.80 and gives you the right to buy the share for a predetermined warrant term, at the fixed price of $10. Now if the Goldilocks Mining share goes up to $15, the warrant would be worth at least $5, because the warrant allows you to buy the share for $10 and immediately sell it again for $15. Rather than actually buying and selling the share, however, you would simply sell the warrant itself for $5. After deducting the purchase price of $0.80, you end up with a profit of $4.20.

Of course if the share price falls, the warrant is effectively worthless because no one would pay $0.80 for a warrant with a $10.00 strike price, when the share itself can be bought in the market for $7. So if you think the share is going to move downwards, the best strategy is to sell the warrant as soon as possible before expiry, in order to limit any losses. In any case, you cannot lose more than the $0.80 warrant that you paid in the first place for the warrant. In short, when you buy a warrant, you know from the very beginning what your maximum possible loss could be.

Put Warrants
A Put Warrant is different in that here you are betting that the share price will fall. Your profits are related to the share price falling rather than rising. Using the same example, a put warrant entitles you to sell one Goldilocks Mining share for $10. In this case, if the put warrant costs 60 cents and the Goldilocks Mining share price plummets to 6 dollars, the put warrants will be worth at least $4 because you can now buy a share for $6 and immediately sell it again, using the warrants for $10. The difference of $4 is your profit, less the initial purchase price of $0.60 of course. If the price rises, say up to $12, the warrant would be worthless because investors could sell the share for $12 in the market, while your warrants is only worth $10. Again, If you think the price will not go back down before the expiry of your put warrant, your strategy would be to sell your warrants as soon possible. Your risk is always limited to the price you paid for the warrant in the first place, in this case $0.60

Gold Warrants
Gold warrants are commodity warrants and related to commodities such as gold and silver for example. Usually issued by mining companies or mints, among the gold warrants available are the Perth Mint, Australia Gold Warrants (PMG).

The Perth Mint Gold product (PMG) is a typical example of a warrant which provides direct, non-leveraged exposure to gold. The PMG product is essentially a right created on-market by Gold Corporation to facilitate trading in gold on market. Remember, that one is not actually owning gold with a gold warrant, but only betting on the movement of the price to ones advantage.

PMGs are structured as long-dated call warrants with a very low exercise price of 50 cents per 100 warrants (no leverage). So here one is betting that the price of gold will rise.

Tracking the international over-the-counter market spot price of gold, the price will be based on the market value of the gold backing (1/100th of a troy ounce).

The minimum exercise set is 100 warrants, which entitles you to take delivery of 1 troy ounce of fine gold (99.99% purity). An additional fee may be payable at the time of exercise, depending on the form of settlement that is elected and there are annual management fees to be paid also.

Owning Physical Gold
Of course this does not compare to owning actual gold. Gold warrants are transitory and eventually one will have to sell the warrant at some time and maybe not at the best or most advantageous time.

Gold warrants may have their place in the market for betting on the gold price, but for the serious investor, there is no substitute for actually owning physical gold.

* Financial Instrument
A real or virtual document representing a legal agreement involving some sort of monetary value. In today's financial marketplace, financial instruments can be classified generally as equity based, representing ownership of the asset, or debt based, representing a loan made by an investor to the owner of the asset. Foreign exchange instruments comprise a third, unique type of instrument. Different subcategories of each instrument type exist, such as preferred share equity and common share equity, for example.