I have previously discussed the high risk/return nature of subscription shares. (Please do read my first article on subscription shares to get you up to speed).
These niche investments give you the opportunity to earn a geared return on the underlying investment trust, and so can increase the money you make by investing.
But there’s a catch – you risk losing your entire investment if the trust’s share price doesn’t rise sufficiently high before the day its subscription shares expire.
Note: Gearing in investing means getting more exposure to an underlying asset for the money you put up. When you buy a house, you gear up your initial downpayment with a mortgage. If you put in say a 10% deposit, then a subsequent 10% rise in the house price will multiply your deposit by 100%, while a 10% drop will wipe it out. That’s the risk/reward of gearing!
Usually when you want to gear up you have to borrow to invest, which is rarely a good idea.
However subscription shares enable you to gear up and multiply your gains without taking on debt. The big risk is that instead of multiplying your gains, you multiply your losses – although your maximum loss is limited to the amount you invest in the subscription shares.1
Warning: Subscription shares are very risky. Don’t even consider them unless you’re a seasoned investor with plenty of experience. I take zero responsibility for any money, fingers, houses or spouses you lose!
Understanding the price of a subscription share
Imagine two kind of shares that give you exposure to the (fictional!) Monevator investment trust:
- Monevator Investment Trust shares (MIT), which have a price of £1.50.
- Monevator Investment Trust Subscription Shares (MSS), each one of which grants you the right to buy one MIT share for £1 on a certain exercise date.
What price will the MSS subscription shares trade at?
The easy answer is that MSS should cost you very close to 50p. That’s because instead of buying MIT in the open market for £1.50, you could buy MSS for just under 50p, and convert them into MIT shares for £1, and so make a tiny profit (because £1 plus nearly 50p is less than the £1.50 that MIT shares would cost you).
The price of MSS will therefore rise or fall as the market arbitrages away any potential anomaly vs. the price of MIT.
In reality, however, MSS’ price will not be exactly 50p unless it’s just a few days – or even hours – before the exercise date. Here’s why.
You know those science fiction films where halfway through a crazy (yet strangely handsome) science geek writes an impossibly complex equation on a blackboard that might just save the world?
That’s the sort of equation that would be required to work out the exactly ‘correct’ price of a subscription share.2
Until the moment it can be exercised, the price of MSS in our example will tend towards the price implied by the trust’s share price and the subscription share’s exercise price but it will also be affected by:
- How much time there is to go until the exercise date
- Supply and demand
- The spread on the shares
- How volatile the underlying investment trust share price is
- And more!
Let’s leave all that for part three, though, since the ‘easy’ price (rounded up to 50p) is close enough to understand the basics of the geared return you’ll get.
How subscription shares multiply your gains
Sticking with our simplified example then, let’s now see how buying the subscription shares gears up the returns you make on the investment trust.
First, let’s suppose that as above:
- MIT is priced at £1.50.
- MSS (the subscription shares) can be exercised for £1.
- MSS is therefore currently trading at 50p.
Now imagine that one of the Monevator Investment Trust’s core holdings invents a cure for cancer / baldness / middle-class ennui, which sends its value soaring.
Let’s say that as result, MIT’s share price doubles from £1.50 to £3.
That’s a 100% return. Nice! But if you were holding the subscription shares you’d have done even better:
- MIT is now priced at £3.
- MSS can still be exercised for £1.
- The price of MSS will therefore now rise to £2.3
So if you’d previously bought MSS shares for 50p, that would be a 300% return – or three times better than if you’d merely bought the MIT shares.
What about losing money?
On the other hand, let’s pretend the cure for cancer kills people, or the baldness cure turns people’s heads purple (and middle-class ennui is obviously unsolvable).
Let’s imagine as a result MIT shares crash from £1.50 to 50p, for a loss of 66%.
Bad – but it will be much worse if you bought the MSS sub shares:
- MIT is now priced at 50p.
- MSS can still be exercised for £1, which is more than you need to pay to buy MIT in the open market.
- MSS are therefore currently worthless.
Ouch – you’ve lost 100% of your investment in the subscription shares.
In a complicated relationship
Now, as I stressed above this example is overly simplified.
In reality MSS wouldn’t go to zero, because until the exercise date had passed there would be some chance of the trust recovering its value.
Equally, MSS wouldn’t post an exactly 300% gain, because MIT’s share price could still fall at any point until the date when the subscription shares can be exercised.
But the rule of thumb, ignoring those complications, is that:
The gearing = (Trust share price / subscription share price)
So in the example above, the MSS shares were three times geared (£1.50/50p), which sure enough we saw with the 300% gain.
In practice, subscription shares can be especially volatile while the underlying trust’s price is below the exercise price. But once it rises above the exercise price, you can roughly assume the subscription shares should move in step penny for penny with the underlying trust.
The gearing on offer, then, depends on how cheaply you can buy the subscription shares versus the trust’s current share price. And that depends on many factors that we’ll consider in part three. (Subscribe to ensure you get it!)
Not much comment on this one… I guess my fellow readers aren’t interested in subscription shares… Have you looked at JIIS? The JP morgan India investment trust subs — right off their highs now. Tempted!
Interesting article. If I have understood all of it correctly (which I might not have:(),
(1) the subscription share option is available only for certain investment trusts.
(2) Once you buy the subscription share, you are on the hook to buy it for a particular price on a given date. If the stock price (in the open market) remains unchanged, you make a very tiny profit; if the stock price rises, you make a substantial profit; and if the stock price falls, you make a loss. The loss would be substantial if the open market stock price falls to less than the price at which you have bought the subscription share (i.e. 50 p, in the example you’ve given). This is where it got a bit confusing for me. If I had bought ordinary shares and if the price fell, I have the option of waiting (and hoping) that the price will rise once again; or I can cut my losses and get out by selling the shares at a lower price. I am guessing that this option is not available to me with subscription shares, because I can’t sell them on their own. In order to make any money I have to convert them into ordinary shares and at a pre-determined price (£1 in your example), which I wouldn’t be interested in because the ordinary share price has collapsed. And because I am on the hook to buy the shares by a certain date, if I don’t exercise that option, it is lost (unlike ordinary share).
Another (naive) query: I would appreciate a great deal if at some time in future you write on the ‘covered calls’ option which, think, is different from subscription shares.
Sorry for the long, rambling mail.
@OldPro — Yes, I don’t expect these posts to generate a lot of interest and that’s a GOOD thing. Most readers shouldn’t go near subscription shares. But they are little covered by the media or even on the Web, so I want to explain them here for completeness.
I haven’t looked closely at JIIS, but the Indian market in general is down a lot this year. I’d need to see the maturity, primarily. I don’t really like sub shares heading towards their redemption date.
@Alan — Did you read the first article (linked to at the top) about subscription shares? That may help you understand more.
To answer your questions, you can buy or sell subscription shares (sub shares hereon, for brevity!) like ordinary shares. Yes, they are only available for certain trusts.
Crucially, you don’t HAVE to buy the underlying shares when you hold subscription shares that reach their redemption/excise date. It is an option to buy, not an obligation.
In practice, most private investors will probably sell a few days before redemption and lock in any gains that way. There may be tax advantages to excising though (I’ll get into that in a future post).
If the sub shares are underwater (i.e. the option to buy is useless, because the underlying trust is trading cheaper) then you will lose whatever money you spent buying the sub shares.
What your describing, if I understand you correctly, is more like a spreadbet. In contrast, an attractive feature of sub shares is this capped liability. But liability it very much is — these are still RISKY products and I strongly suggest anyone does a lot more research before investing, and then only invest a few hundred quid until you see how they work in practice (not least their volatility).
I’ve never written covered call options, I’m afraid, so I won’t be telling anyone how to do it. If I do in the future, I’ll try to remember your request!
Thanks to you and OldPro for your comments.
Thanks for your detailed (and patient) reply. Having gone through both of your postings, your reply + googling:), it is a lot clearer. And the message flashing is I should steer clear of them for the foreseeable future.
Wow this site looks interesting and I’m not even sure if it is alive.
My position is that I was allocated free subscription shares at the start of my investment. This year is my last opportunity to exercise them. Ordinary share price is currently at 352.30 Subscription share price 125.25 and the exercise price is 218.94 . Is it too simplistic to believe that by exercising at 218.94 I stand to make a very good return of 133.36 (less any trading charges) per share given that I did not have to pay to purchase the subscription shares in the first place?
@Max — If you didn’t pay for them and got them free, then it’s free money. (An efficient market theorist would say it was in the price you paid when you first invested one way or another though).
If you exercise your sub shares, you will need to have sufficient capital (cash) to buy the number of shares it entitles you to buy. Sometimes you might be offered the option of selling sub shares to fuel the purchase or similar (like you sometimes get with rights issues) but that’s the gist of it.
However you could sell the subscription shares in the open market instead, like any other share. If they are currently priced at 125p, then (ignoring spreads etc) you can sell them for 125p each and collect the cash. The downside is you’d miss any further gains from here, and that at 125p they’re a few pence cheaper than their apparent intrinsic value of 133p on the numbers you’ve given here. (Someone buying them off you would be buying to exercise to capture that extra gain, I guess). But the advantage is no capital required etc, and obviously the share price and hence the sub price could decline from here, too — it’s only a profit when you sell. 🙂
None of this is personal advice, which I cannot give you, please do your own research and consult an advisor if required etc.