What are Stock Warrants?

A stock warrant is similar to a stock option. Just like options, warrants are issued as both calls and puts. A call warrant gives the holder the right, but not the obligation, to buy shares at a certain price on or by the expiry date. A put warrant gives the holder the right, but not the obligation, to sell shares at a certain price on or by a certain date.

The main difference between a stock warrant and a stock option is that a stock option is an exchange issued and traded financial instrument, whereas a stock option is issued by the company to which the warrant applies.

Companies often issue warrants when they issue new shares. They are a way of encouraging investors to buy the underlying shares, without the need for the investor to immediately part with the full cost of the shares. Over the lifetime of the warrant if the share price rises, then the purchase of the shares becomes more viable and the warrant value will increase.

This article concentrates on call options for ease of explanation.

Elements of a Stock Warrant

There are three main elements that determine the price of a warrant:

The Strike Price

This is the price at which the warrant allows the investor to buy the underlying shares. This will be the main driver of price of a warrant. For example, if a warrant allows an investor to buy 1 share at a price of $1.20, and the current price of the underlying shares is $1.50, then it’s fair to say that the warrant has an intrinsic value of $0.30.

The Expiry Date

All warrants are valid for a set period of time. The last day on which a warrant can be exercised is called the expiry date. The longer the time until expiry, the higher the price of the warrant: this is because the share price of the underlying stock has a greater time to move toward the strike price of the warrant.

The Conversion Ratio

This is the number of shares applicable to the warrant. For example, a warrant may be issued by ABC which gives the holder the right to buy one share for every four warrants. In other words, when exercising the right to buy shares, the warrant holder would have to ‘hand back’ three warrants – plus the strike price – for every share he is converting the warrants to.

Calculating the value of a warrant requires factoring in interest rates, time, exercise (strike) price, and conversion ratio. But, simply stated: the higher the price of the underlying share and the longer the time to expiry then the higher the price of the warrant.

Uses of Stock Warrants

You can use stock warrants to speculate on the price of the underlying stock, or to hedge an existing position. They can be freely traded, with registration transferred between holders, and as the cost is comparatively low they are attractive investments.

This low price means that the gearing on warrants is high. This means that the potential profit is higher than if an investor had bought the shares outright. But, so too, is the potential risk. Warrant prices tend to move in line with the price of the underlying share. However, because the price of the warrant is far lower, the percentage change is far higher.

To illustrate this, consider the following example:

ABC call warrants give the holder the right to buy one share per warrant at $1.00. The share price is currently $1.50. The price of the warrant is $0.50. (For the sake of this example we are discounting time value, and other pricing parameters.

If the share price rises to $1.70, the price of the warrant will rise to $0.70. The shares have increased by 13%, whilst the price of the warrant has increased by 40%.

However, if the share price were to fall by $0.25 to $1.25, the warrant will fall to $0.25. The shareholder has lost nearly 17%, but the warrant holder has lost 50%.

Are Warrants for You?

Warrants offer a cheap way to gain exposure to stock, and offer gearing that can ramp investment profits. But that gearing also means that losses can mount rapidly too: there’s never reward without risk.

They can be used to hedge positions as well as speculate on a market move, though they are often used for longer term investment purposes. If you believe a stock will reach the exercise price of a warrant by the expiry time, buying the warrants means paying out less money up front for the exposure you want.

Of course, it should be remembered that warrant prices can drop to zero, and become worthless, particularly in bear markets. In bull markets, warrant traders and investors can make very healthy profits.

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