All About Stock Warrants – Warrants vs. Options
What is a Stock Warrant?
A stock warrant is a contract in which a company provides new shares for sale, and offers the buying public (i.e. investors) the rights to purchase these stocks at a specified price and on a specific date.
This definition brings up certain elements of the stock warrant transaction.
- There are two entities, one of which must be the company as the selling entity. The other entity are investors, traders and corporate entities.
- The company stocks are the assets which are offered for sale.
- New stocks have to be created for sale as stock warrants, which dilutes the company ownership.
- The buying entity still retains the right to purchase the stock warrant at a later date even if the warrant has expired.
If you are familiar with options trading, you can see that the definition closely resembles that of options trading. However, look at the definition of an option.
An option is a contract that exists between two parties which gives the option holder the right to buy or sell that option at a specified price and date but does not obligate that holder to do so.
You can see that there are some similarities and some differences between the stock warrant and the stock option. These will be identified later in the article, but let us look at the stock warrants and find out what we can about them.
How Stock Warrants Work
There are many reasons why a company may want to sell stock warrants, but the primary reason is usually to raise cash. Also, a majority shareholder may want to divest some of the holdings in that company, and may then opt to use the stock warrant as a way of achieving this. On the flip side, traders and investors who want a piece of a company may decide to acquire some part of the ownership using the stock warrant pathway, especially when that purchase is to be made in the future.
A company may decide to provide stock warrants in blocks of 100 shares each (i.e. a full contract) at a price of $10 per share over a period of 12 years. Obtaining the warrant enables the investor to exercise the option of buying the stock warrant at any time within the 12-year period at the same price of $10, even if the stock had increase in price within that time frame. This enables the stock warrant holder to get an immediate profit, which is the difference between the strike price of $10 and any price that is greater than $10 that the stock is selling at that time (must be higher than $10).
Here, $10 is the strike price and 12 years is the expiration time and here, the goal is to lock in the price at $10, expecting to get a profitable return when the stock warrant is exercised in future.
So if an investor purchased 500 units of these stock warrants at $10 and the stock price rose $17 per share in 3 years, the value of the portfolio is not 17 X 500 = $8500. The profit would be (17-10) X 500 units = $3500.
Components of a Stock Warrant?
Here are the features of a stock warrant:
- Price: A stock warrant price (or the exercise price) is the price at which the stock warrants are sold.
- Expiry: The expiration date is usually shown on the contract document.
- Number of shares to be sold.
- Conversion ratio: this indicates the ratio of conversion which is used to calculate the number of shares that can be derived from a certain number of stock warrants.
Benefits of Stock Warrants
Stock warrants have some benefits that make them advantageous when compared to stock options or other investment vehicles.
- Stock warrants are not complicated and therefore they are suitable for unsophisticated investors.
- They are usually offered at discounted prices to make them more attractive.
- They have the potential for high returns over the long term.
- Stock warrants can be transferred as inheritance from parents to their kids.
Stock Warrants vs Stock Options
This section will compare stock warrants with stock options to see the areas in which they are similar, and those where differences exist. So what are the comparison points between stock warrants and stock options?
- They are both financial contracts to purchase a company stock
Both stock warrants and stock options are investment contracts that allow investors to purchase a company stock at a fixed price and at a fixed date. They can both be purchased on a stock exchange, involve a buying and a dealing party and also follow all the terms of a financial contract.
- They deal with a single asset entity: stocks
The only assets that change hands in both stock warrants and stock options is STOCKS. No other asset (such as commodities or bonds) are traded. It is purely stocks.
Now that we have the two basic similarities between the two, let’s move on to the differences. How do stock warrants differ from stock options?
- Stock warrants are designed to last for a long time and have long investment windows. However, stock options do not last very long. The longest stock options tend to last for a few months, while the shortest last for as little as a week.
- For the reason that has been adduced in (a) above, the investment focus for both are different. Long-term investment focus will be best suited for those who want to trade stock warrants, while traders with a short term view will find stock options to be a better option.
- Stock options are standardized contracts which are purchased on the floor of an exchange or using an electronic trading platform. Stock warrants are usually not standardized.
- The stock exchange is usually the issuer of a stock option, while the issuing company itself is the issuer of the stock warrant. As such, the operational terms and conditions that the contracts operate by are set by the exchange for stock options and by the company in the case of stock warrants.
- The stock warrant is a primary market instrument, since it is issued directly by the company. Conversely, stock options can only be sourced from the exchange and are therefore secondary market instruments.
- For the same reason as has just been stated, stock options are more liquid and easily tradable, whereas stock warrants cannot be traded easily.
- To be able to issue stock warrants, new shares have to be created and this causes a dilution of the issuing company’s stocks. Stock options do not involve creation of new shares, so no stock dilution is involved.
- Stock warrants are a form of capital generation instrument for the company issuing them, and they are a way to profit from price appreciation in the future for the warrant holder. In contrasts, stock options are purely speculative derivatives which are used for market speculative activity.
- A stock warrant actually has to be exercised at a higher price than it was purchased to be able to make money, while some stock options do not need to exercised to be profitable (especially if the stock option led to the receipt of a premium at the start of the trade).
So that’s it. This is what stock warrants are all about and the differences between them. Want to start trading? Read our list of online stock brokers.
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