What Are Stock Warrants and How Do They Work?
What Are Stock Warrants?
Stock warrants are securities that give the holder of the warrant to purchase or sell a set number of shares in the issuing company at a specific price over a certain period of time. Strike price refers to the price at which the warrant holder can buy or sell the specified number of shares. Expiration time is the date when the warrant expires and ceases to be an enforceable contract unless exercised earlier. Stock warrants are issued by companies as well as governments. Companies usually issue them for the purpose of raising capital.
How Do Stock Warrants Work?
Stock warrants work similarly to options. In a call warrant, the holder is given the option to buy shares from the issuer while in a put warrant, it is an option for him or her to sell shares. Call stock warrants are more common than put warrants. In general, the price at which the stocks can be bought or sold will be higher than its current market value when a stock warrant is issued and initially traded. Thereafter, this difference decreases over time until expiration of the warrant where it will converge to zero if there has been no change in share prices. This discrepancy between market value and strike price attracts investors who see potential benefits in exercising their warrants early before expiration date rather than holding them till maturity or expiration date when they would have no value. Holders of stock warrants are not bound to exercise their rights; they can sell them in the market at any time, even after expiration date before it has no value.
Stock Warrants Types
There are two major types of stock warrants: call warrant and put warrant.
A call warrant gives the holder of the warrant the right to purchase stock from the issuer at a set price on or before a certain date. An investor is compensated for buying call warrants as he is given some amount of cash per share purchased under the warrant.
A put warrant gives its holder, also known as payer, the right to sell shares back to the issuer at a set price on or before a certain date. The value of the put warrant decreases as time goes by and it expires over time and becomes worthless if not exercised. Put warrants are typically issued with lower strike prices than those with call warrants; but, because they give their holders more time, investors receive greater compensation for holding them.
Examples of Stock Warrants
Call Warrant Example
A company issues a call warrant to a bank and the terms and conditions of this agreement state that: The holder can buy 1,000 shares in the company at $10 per share on or before 10 years after the issue date. In this example, strike price is $10 while the expiration time is 10 years from the issue date. This stock warrant gives the holder the right, but not the obligation, to purchase 1,000 shares at $10 per share. If, in case, the stock sells at $20 per share, the holder will have the privilege to purchase the stock at the agreed strike price of $10 per share. This means that as the price of the stock increases, the more valuable the warrant becomes since the strike price is fixed. Additionally, the holder of the warrant has the right to exercise the terms of the warrant within 10 years from its issue date. After the expiration date lapses, the warrant will no longer be effective.
Put Warrant Example
A company issues a put warrant to a bank and the terms and conditions of this agreement state that: The holder can sell 1,000 shares in the company at $10 per share on or before 10 years after the issue date. In this example, strike price is $10 while the expiration time is 10 years from the issue date. This stock warrant gives the holder the right, but not obligation, to sell 1,000 shares at $10 per share. If the price of the stock falls below $10, the company will be forced to buy it from the holder at the agreed price of $10 per share. This means that as the price of the stock decreases, the more valuable the warrant becomes for the holder.
Risks of Stock Warrants
Stock warrants give holders of these securities an opportunity to earn profits by purchasing them at a low cost and selling them when the share prices rise. However, it is possible for them to lose money if the share values fall instead of rising or remain stagnant. This makes stock warrants risky compared to other common financial investments such as bonds and stocks which offer fixed interest rates.
Benefits of Stock Warrants
Stock warrants can be valuable investment tools because they allow investors to participate in the potentially high returns offered by companies with promising products but without enough capital.
The Difference Between Stock Warrants and Stock Options
Stock options are more commonly issued than stock warrants while both can be used for investment purposes. The most notable difference between the two is the issuing party. Stock warrants are issued by companies while stock options are issued by traders on the secondary market. This means that stocks options are used as derivative securities while stocks warrants are embedded in the company’s stock. In terms of flexibility, stock warrants have a longer expiration date compared to stock options which have shorter expiration periods.
Stock warrants are strong investment tools that offer an opportunity for investors to earn profits by purchasing them at a low cost and selling them when the share prices rise. However, it is important for potential investors to understand the risks involved with stock warrants before making any purchases. This will help them to know whether stock warrants are a good or bad investment for their financial circumstances.
About the Author
True Tamplin, BSc, CEPF®
True Tamplin is a published author, public speaker, CEO of UpDigital, and founder of Finance Strategists.
True is a Certified Educator in Personal Finance (CEPF®), author of The Handy Financial Ratios Guide, a member of the Society for Advancing Business Editing and Writing, contributes to his financial education site, Finance Strategists, and has spoken to various financial communities such as the CFA Institute, as well as university students like his Alma mater, Biola University, where he received a bachelor of science in business and data analytics.