What Is a Stock Warrant?
A stock warrant is a derivative security that allows a warrant holder the right to buy or sell a company’s stock at a fixed price by a predetermined date.
While a warrant holder isn’t obligated to follow through with the transaction, their warrant does become worthless, however, if the holder doesn’t exercise it by a specific date.
A stock warrant is a derivative, which means it’s tied to the performance of an underlying security—in this case, the common stock of a publicly traded company. Companies issue warrants for a variety of reasons, including to raise capital for funding operations and as incentives for employees as an additional form of compensation.
What Are the Different Types of Stock Warrants?
There are two fundamental types of warrants: calls and puts. A call warrant allows its holder to buy shares at a specific price in the future, while a put warrant allows its holder to sell shares at a specific price in the future.
How Does a Stock Warrant Work?
An investor can purchase a company’s warrants from their broker. Buying call warrants could be a good strategy to use during a rising stock market, while put warrants might be successful during a bear market.
Warrants tend to be more sensitive to price changes than common stock, and consequently, they carry more risk. The price of a warrant isn’t necessarily the same as the underlying stock’s price. A warrant’s exercise price is the guaranteed price at which an investor may buy the stock prior to the warrant’s expiry.
An investor betting on a company’s stock rising in the future would buy call warrants, and the payoff from a minimal investment could be potentially significant, depending on how much the company’s stock goes up in value by the time the investor chooses to exercise.
Stock Warrant Example
Say an investor has analyzed a company’s income statement and future prospects and predicts its shares are likely to go higher. That company sells warrants, and the expiration date is listed at 10 years from the date of sale. These warrants are listed on a stock exchange, and the investor places orders for the warrants via an online brokerage. The price for a warrant is $1, but the exercise price (or the amount to acquire the share) is $2, which means paying a total of $3 by the expiration date.
If the company's stock price increases to $6 in five years, the warrant can be exercised at that market price, and the warrant holder will be issued new stock. Since the total price for the warrant is $3 (the price of the warrant and the exercise price), that results in a profit of $3, or a 100% return on investment.
In the Money vs. Out of the Money Stock Warrants
The exercise price for the warrant in the example above is $2. If the company’s shares trade at $6, that puts the warrant “in the money” by $4.
When a warrant is in the money, that means that the current price of the underlying stock is higher than the warrant’s exercise price. Out of the money, on the other hand, means the opposite—that the exercise price of the warrant is higher than the current price of the underlying stock. If a warrant is out of the money, there is no reason for an investor to exercise it.
It's important to keep in mind, however, that just because a warrant is in the money doesn’t mean it is worth exercising. In order for an investor to make a profit on a warrant, the current price of the underlying stock must be higher than the sum of the warrant’s purchase price and its exercise price.
In the example above, for instance, say the investor holds the warrant and waits for the 10-year expiration date, but when it approaches, the price of the underlying stock is only $2. If they were to exercise, they would pay $3 total (their purchase price plus their exercise price) for a stock that is only worth $2, so they would experience a capital loss to the tune of $1. In this case, rather than redeem the warrant and pay $3, the investor would let the warrants expire worthless and incur a capital loss of $1.
How Does a Stock Warrant Differ From an Options Contract?
There are notable differences between a stock warrant and an options contract on a stock. Among them, a warrant is offered directly to an investor by a publicly traded company, which uses the proceeds from the sale to finance operations. An option, on the other hand, is offered by traders on the secondary market.
That being said, stock warrants can be resold on the secondary market after being purchased from the issuing company.
Additionally, warrants tend to have longer durations, with many expiring 5 or even 10 years after they are issued, while options, on the other hand, have shorter durations—typically a year or less.
Frequently Asked Questions (FAQ)
The following are answers to some of the most common questions investors ask about stock warrants.
What Is the Difference Between a Share of Common Stock and a Stock Warrant?
A stock warrant’s price is tied to the price of a company’s common stock, and that makes a stock warrant a derivative instrument. A share of common stock represents partial ownership of the issuing company.
Are Stock Warrants Offered as New Stock?
When stock warrants are exercised, new stock is issued by the company.
What Is the Exercise Period of a Stock Warrant?
The exercise period refers to the time period during which an investor may convert their warrants into common shares prior to expiration. American-style warrants can be converted at any time between issuance and expiry.
How Do Stock Warrant Expiration Dates Work?
In the U.S., stock warrants can be redeemed prior to or on their expiration dates. In other countries, such as in Europe, redemption of warrants can be done only on the date of expiration. Failure to redeem by the expiration date in either case renders the warrants worthless.
