Effective gearing

Effective gearing, also called the elasticity of a derivative, is closely related to delta. Delta is the ratio of absolute price changes, whereas effective gearing is the ratio of relative price changes. It is most often used in the context of warrants. It is:

effective gearing = percentage change in price of warrant ÷ percentage change in price of underlying

This is closely related to the delta. The gearing of a warrant is (the rate at its intrinsic value changes with changes in price of the underlying).:

gearing = price of underlying ÷ (price of warrant × conversion ratio)

and:

effective gearing = delta × gearing

Effective gearing is an intuitively understandable; delta is used for hedging, and therefore for valuation. Effective gearing is therefore most useful for speculative investors who looking at the relationship between the derivative, and the underlying security on which they wish to take a punt.

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