What is a Stock Warrant?

There has been a buzz about warrants of late, though these instruments have been available to investors for decades — a period when they’ve been highly underappreciated and overlooked. Through the years, companies like AT&T, Bank of America and General Motors, among hundreds of others, have had stock warrant trading.

But there’s a caveat; stock warrants are less accessible and more obscure than equities. Even so, these financial derivatives carry unique features that make them an attractive investment option. That’s why you should educate yourself on this seemingly mysterious market.

Today, we provide the inside scoop on stock warrants and how you can use them to your advantage.

What is a Stock Warrant?

A stock warrant is a financial derivative that gives investors the right to purchase or sell a company’s stock at a specific price (the strike price) before the warrant’s expiration date. In many ways, you’ll find that a warrant is similar to a stock option, except stock warrants are issued by companies while options are issued by traders.

How Stock Warrants Work

Stock warrants are either call or put warrants. When you buy a call warrant, you can choose to purchase the security for a specific price before its expiration date. When you purchase a put warrant, you’ll be able to sell the security for a specific price before its expiration date. You’ll probably not execute the warrant if it lives to its expiry date without being in the money or profitable.

Let’s put this into perspective with an example.

Say company ABC trades for $30 per share. The company also has some warrants trading on the open market that let you purchase the stock for $40 per share 5 years from now. The warrants are currently trading at $2 each.

Your warrant will be profitable (in the money) if the stock price exceeds the cost of the warrant plus the exercise price at the expiration date. In this scenario, your warrant will be profitable if the company shares traded at $42 ($40 exercise price + $2 warrant price).

If ABC traded for $50 per share in 5 years, the warrants would be worth $10 each, so the return on your warrant would be 400%. But, if company ABC shares are less than $30 in 5 years, your warrants will expire and be worthless — you’d lose your entire investment.

Benefits of Stock Warrants

Stock warrants are incredibly beneficial to investors who have an in-depth understanding of the company and the entire market. So let’s fill you in with the benefits of stock warrants in detail.

• High returns in the long run: The return on stock warrants is higher because they generally take a long-term investing approach. You can wait several years before exercising the warrant. With time, there’s a higher possibility that the company’s share price will surpass the warrant strike price, which could give huge returns. Most companies generally earn higher profits in the long term.
• Transparency: It’s easy to track the performance of a stock warrant by monitoring the movement of the underlying securities.
• Low cost: Warrants are often priced lower than the company’s shares, which makes them a better alternative to standard stocks.
• Capital management: Stock warrants let you buy shares or securities at a future date, which gives you ample time to accumulate the required money over the period instead of taking credit immediately.
• Beneficial to speculators: Stock warrants can be a great investment tool for the speculators who closely follow the market performance, hoping to profit from a bull or bear run.

Risks of Stock Warrants

Stock warrants carry a few risks, which make them an unsuitable vessel for those who are not knowledgeable about the stock market. Some of these risks include:

• High risk: The performance of a stock warrant largely depends upon the return of its underlying stock. Unfortunately, market fluctuations can render a stock volatile, which can aggravate the risk of stock warrants.
• Limited control over the issuing company: As a warrant holder, you won’t have the same rights as a company’s shareholder. For instance, you can’t partake in annual general meetings of the issuing company.
• Additional complexity: Stock warrants are sophisticated. They are not created equal — their terms depend on what the issuing company stipulates. Sometimes a profitable call warrant may be called back by the issuing company, forcing you to sell.
• Drop-to-zero value: Profits aren’t always guaranteed with stock warrants. If a company’s stock price falls below a warrant strike price, your warrant will expire worthless and you may lose part or your entire investment.

Stock Warrants and Stock Options

In many ways, stock warrants and stock options are similar. They both give you the right to purchase and sell an underlying stock at a specific price before the expiry date. The main difference between both, however, largely comes down to the parties involved.

With stock options, the participating parties are usually both traders — one investor is looking to sell the option to another. As a result, a company whose stock options are traded doesn’t receive any proceeds from the options trades.

For stock warrants, one party is usually an investor, and the other party is the company whose stock this warrant represents. As a result, any proceeds raised by a stock warrant are directed back to the issuing company.

Stock options can only trade shares that already exist on the market. Since the underlying company is responsible for issuing stock warrants, it can issue new shares when holders exercise their warrants. For this reason, companies often use stock warrants as a mechanism to raise capital.

The table below breaks down the differences between the two.

Examples of a Stock Warrant

A company looking to issue a series of warrants could structure them as either call or put warrants, as you will see below.

• An American-style call warrant for 500 shares of ABC company stock at a strike price of $40 within 5 years (the expiration date)

This stock warrant gives you the right to buy up to 500 shares of ABC stock at $40 per share. This implies that even if a share is selling at $70 per share, you can still purchase it at $40 per share. The higher the stock price, the more valuable your stock warrant becomes. You can exercise your warrant at any time within the 5-year period, otherwise, your warrant will expire worthless.

• A European-style warrant for 2,000 shares of ABC company stock at a $70 strike price on December 31

This put warrant now gives you the right to sell up to 2,000 shares of ABC shares back to the company for $70 per share. Even if the company’s share price is $20, it will still have to buy this warrant from you at $70 per share. The lower the stock price drops, the higher the value of your warrant. You can only exercise a European-style warrant only on its expiration date.

Companies rarely issue put stock warrants since they don’t want to bet against their own stock.

Additional Considerations

Remember, a company can choose what ratio to base the warrant on. One share may equate to 5, 10 or 20 warrants. Be sure to understand all the stipulations before exercising a warrant so that you end up with the desired number of shares.

Sometimes, due to specific circumstances or an extraordinary event, a stock warrant may expire before its actual expiration date. And because of their life span, warrants will expire on their designated date even if you don’t realize the desired returns.

Stock Warrant Taxes

Stock warrants and stock options have different tax rules. Stock options may get preferential tax treatment while warrants don’t enjoy similar breaks. Also, exercising warrants often results in taxable income.

Stock Warrant Investments

Stock warrants are attractive for investors eyeing a medium- to long-term investment strategy. These largely unexploited investment tools carry high risks as well as the potential for high returns, which makes them an excellent option for speculators.

Best Online Brokers for Stocks

Benzinga maintains a list of the best online brokers you can use to trade stocks.

The Bottomline

Because of the outsized gains or losses stock warrants create, it’s advisable that you tread carefully and use them sparingly. And unlike common stock, the profitability of stock warrants depends on a set timeline, adding the risk that a company’s stock price may not rise by the warrant’s expiration date. Even so, this investment alternative lets you diversify without wrestling it out with the big boys.

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