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A stock warrant is a contract that lets you buy or sell shares of a company’s stock at a specific price on a specific date. Warrants are similar to options contracts, although there are certain big differences between the two.
For the average retail investor, derivatives like warrants and options aren’t really necessary. Though they can help to diversify a portfolio, given the risk they carry from leverage, investors need to be very attuned to price changes and market volatility.
Understanding Stock Warrants
A stock warrant is a derivative contract between a public company and an investor. A warrant gives the holder the right to buy or sell shares of stock to or from the issuing public company at a specified price before a specified date. Holders of warrants are under no obligations to buy or sell the underlying stocks.
Like options contracts, warrants carry a strike price. This is the price per share at which the holder can buy or sell the stock. They also carry an expiration date after which they become useless.
Typically one warrant gives the holder the right to buy or sell one share of stock. When the warrants are exercised to buy a stock, the company issues more shares—these new shares are dilutive for existing shareholders, meaning they diminish the concentration of ownership the shares previously had.
Though you receive shares directly from the company when you exercise warrants, they can be held in a normal trading account with an online broker. You simply buy or sell them as you would a stock.
Types of Warrants
There are two types of warrants: put warrants and call warrants. Put warrants allow holders to sell shares of stock they already own while call warrants allow investors to buy shares of stock.
Most warrants are call warrants, which let holders buy a stock at a specified strike price during a certain period that ends on the warrant’s expiration date. An investor should only exercise the call when it’s in the money, meaning that stock’s market price is greater than the exercise price.
Consider a call warrant with a strike price of $110. If the market price of the underlying stock is priced at or below $110, the investor should allow the warrants to lapse. But if the underlying stock price is $150, the investor should exercise the warrant and get a $40 discount when buying one share of the company’s stock.
Put warrants give the holder the right—but not the obligations—to sell a specified number of shares back to the issuer at the strike price. Put warrants are exercised at the strike price and are in the money only when the market price falls below the strike price.
To continue the example from above, that would mean the underlying stock would need to be valued below $110–otherwise, they would lose money.
Other Aspects of Warrants to Keep in Mind
Warrants of all types are classified based on how you’re able to exercise them. An American warrant can only be exercised anytime on or before the expiration date while European options can only be exercised on the expiration date. Both types of warrants are issued in both the US and Europe.
Warrants also often have a conversion ratio. This specifies the number of warrants necessary to buy or sell one share of stock. If a conversion ratio is 4:1, it means that it takes four warrants to buy one share.
Why Do Companies Issue Warrants?
Companies issue warrants for a variety of reasons:
- To raise capital. If a company needs to increase its funding, it will sell warrants in the open market or to financial institutions for resale. The company generates capital through both the sale of the warrants and the sale of stock when the warrants are exercised.
- To fund acquisitions. Similarly, a company may include warrants, in addition to cash, to finance the purchases of other companies.
- To encourage bond or preferred stock purchases. A company may sweeten a bond or preferred stock with warrants. It might also issue bonds with a warrant attached so purchasers can benefit from rising share prices by exercising their warrants when share values reach enticing conversion thresholds.
- To attract employees. Warrants can be offered as an additional component of compensation to help attract new employees and retain existing staff. Typically, these warrants are European-style contracts, with exercise dates several years in the future to incentivize new employees to remain with the company.
Warrants and Taxes
Holders of warrants don’t enjoy many of the tax benefits that shareholders do. In the context of employee compensation, options may receive more favorable tax treatment while warrants do not.
When they’re exercised, warrants generate taxable income on the difference between the exercise price and the stock price, less the amount paid for the warrant. They are taxed as capital gains since the warrant holder does not own shares in the company. Income is taxed as ordinary income on exercise, which can be troubling if you’re in a high tax bracket.
Warrants vs. Options: What’s the difference?
Warrants and options are similar in certain regards:
- Each grants the chance to buy or sell assets at an agreed-upon price on or before a date in the future, depending on whether they’re American or European style.
- Warrants and options enable investors access to leverage by letting them lock in a future price for a small amount of money, called a premium, now.
- Both have a strike price and an expiration date.
- They are in or out of the money depending on whether the stock price is higher than the strike price (for a call) or lower (for a put).
Warrants and options differ in a few key aspects:
- Warrants are issued by a company whereas options are created by market participants and traded in the secondary market.
- Options can be used as speculative instruments or to generate income. They’re often used to hedge positions in other assets.
- Options contracts are short-term, rarely longer than a year and sometimes only days, weeks or months. Warrants are instruments that extend over the long term, as long as five to 10 years.
- When a warrant is exercised, the new stock issued is dilutive to existing shareholders.
- Warrants are used to raise capital for companies and attract investment while options generate no capital for companies.
Advantages of Warrants
- Given their inherent leverage, warrants offer significant potential on the upside.
- With longer time horizons, investors have a greater window of opportunity to see their bets pan out.
- When the issuing company pays dividends, it may adjust the strike price downward.
Disadvantages of Warrants
- Warrants have increased risk and volatility.
- Warrant holders are at a disadvantage to shareholders because they don’t have voting rights or a right to dividends.
- Warrants are highly complex and may suffer from a lack of availability.
- They are likely to be issued by more speculative companies.
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The Bottom Line
As with all derivatives, considerable skill and experience are necessary to enjoy the advantages of these instruments while avoiding the pitfalls. Investors interested in adding warrants to their investment portfolio would be well advised to see guidance from an experienced financial advisor.