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Once you feel confident with investing, you may decide it’s time to explore more advanced investment strategies such as derivatives. Derivatives are generally contracts between two investors that either allow or require investors to make certain transactions in the future.
A stock warrant is a common type of derivative that allows investors to purchase a company’s stock, often at a discount. Learn how stock warrants work, how they compare to other derivatives, pros and cons to be aware of, and how to get started investing with stock warrants.
The Short Version
- Stock warrants allow an investor to buy a company’s stock at a certain price at a specific date. Unlike options, stock warrants are a deal between the company and investor and not two private parties.
- It’s a type of derivative, meaning the value comes from the underlying asset, which in this case is the stock.
- When investing in stock warrants, it’s important to know the expiration date and the strike price. This determines when the stock can be bought and at what price.
What Is a Stock Warrant?
A stock warrant is a contract between a company and an investor that gives the investor the right to purchase a company’s stock at a certain price at a specific date in the future. A warrant is a type of derivative, meaning its value is derived from an underlying asset — in this case, the company’s stock the investor has the right to purchase.
Stock warrants have two important characteristics: the expiration date and the strike price. Warrants only give the investor the right to purchase the stock for a certain amount of time. If the expiration date listed in the contract passes, they forfeit that right.
The strike price is the price at which the investor can purchase the stock. It’s often a premium on the stock’s market price at the time the two parties enter into the contract. As a result, it’s generally only worthwhile for the investor to exercise the warrant if the company’s stock price increases to an amount that’s higher than the warrant strike price.
When an investor exercises a warrant and purchases the company’s stock, it increases the capital available to the company. While this is a positive thing for the company, as it has more working capital, it could be a negative thing for existing shareholders.
Because the company issues new shares when a warrant is exercised, warrants are dilutive in nature. They increase the number of a company’s outstanding shares, which means each share is then worth a slightly smaller portion of ownership in the company.
For example, suppose that Company ABC had 100 outstanding shares owned by 10 different shareholders, each of whom owned 10% of the company. Company ABC issued a warrant to a new investor, giving them the right to purchase 10 shares of company stock. If the investor exercises the warrant, each shareholder (including the new investor) will own just over 9% of the company.
How Many Types of Stock Warrants Are There?
There are two different types of warrants:
- A call warrant gives the investor the right to purchase a company’s stock at the strike price before the expiration date.
- A put warrant gives an investor the right to sell the stock.
Call warrants are most common and are what we’re generally talking about when we discuss warrants.
Stock warrants are often used in conjunction with convertible bonds. A convertible bond is a type of fixed-income debt security that a company issues to raise capital. Bonds, like other debt securities, are a type of temporary capital which the company will eventually have to pay it back.
A convertible bond gives the investor the right to convert it into common stock at a certain point during the bond’s life. The purchase is often done using a stock warrant, which the investor receives from the company alongside the convertible bond.
Find out more >>> How to Invest in Bonds
How Do Stock Warrants Compare to Stock Options?
Stock options are another popular derivative that gives contract holders the right to buy or sell stock at a specific price before a specific date.
There are two types of options: call options and put options. Like call warrants, a call option gives an investor the right to purchase an underlying stock for a strike price before the expiration date. A put option gives an investor the right to sell the stock for the strike price before the expiration date.
Suppose two investors enter into a call warrant that gives Investor A the right to purchase a stock for $25 from Investor B. Currently, the stock is trading at $20, but Investor A thinks the price is going to increase to at least $30. If the price does increase, then Investor A can essentially buy the stock at a discount. If it doesn’t increase, then Investor A would simply allow the option to expire, with their only loss being the price of the contract.
Stock warrants and stock options are similar in several ways. Each type of derivative gives an investor the right to buy or sell an underlying stock for a specific price before the expiration date in the contract.
But there are also some key differences between the two derivatives. First, while a stock warrant is a contract between a company and an investor, a stock option is a contract between two private parties — the company that issued the stock isn’t involved.
Another difference between warrants and options is where they’re purchased. Options can be traded either at exchanges or over the counter. A warrant, on the other hand, is issued by the company and often comes alongside the purchase of a convertible bond.
Warrants and options also differ in their expiration dates. Stock warrants often give the investor the right to purchase the underlying stock for up to 15 years. Options, on the other hand, often have expiration dates of just a few months or up to two to three years.
Finally, when a call option is exercised, one investor exercises their right to buy existing company shares from another shareholder. But when a warrant is exercised, the company issues entirely new stock to fulfill it.
Read more >>> What is Options Trading?
How to Sell or Exercise a Stock Warrant
If you own a stock warrant, you generally have three choices: exercise the warrant, sell the warrant or allow the warrant to expire.
The only time you would want to exercise a stock warrant is when the stock’s market price is higher than the strike price in the contract. In this situation, you’re essentially buying the stock at a discount.
Suppose you purchased a stock warrant that allows you to buy a stock at $20 per share, but at the time the warrant is issued, the company’s stock is only trading at $10 per share. Over the course of several years, the company has a wave of financial success and its stock price rises to $30. You can exercise your warrant and buy the shares for $10 per share less than the market price.
Warrant contracts require that investors give the company a “heads up” if they plan to exercise the warrant. The investor lets the company know they plan to exercise the warrant, which gives the company time to issue new shares for the investor to buy.
The simplest way to exercise a warrant as an investor is to enlist the help of your broker. The broker will coordinate with the company, give them the heads up and handle any paperwork. Once the warrant has been successfully exercised, the shares will appear in your trading account where the warrant once was. You can check out our top recommended brokers in our online stock broker guide.
If you have no intention of exercising your stock warrant but also don’t want to let it expire, you can also sell it to another investor. You might decide to sell your warrant if the stocks’ market price hasn’t yet risen above the strike price in the warrant, and you don’t want to wait for that to happen.
Keep in mind that the amount you’ll be able to sell your warrant for depends on how much risk the other investor is taking on. If the warrant is nearing its expiration date and still isn’t in the money, then you won’t be able to sell it for as much as you would if there was a long time before the expiration date or the warrant was in the money.
If you decide to sell a warrant that’s in the money, it makes sense to sell it for at least as much as the profit you could receive by simply exercising the warrant and selling the stock. Suppose you had a warrant for a stock with a current market rate of $30 per share, and your warrant gave you the right to buy the shares for $20 per share. You would want to sell your warrant for at least $10 per share since that’s your potential earnings from exercising the warrant and selling the stock.
Pros and Cons of Stock Warrants
Before you start investing with stock warrants, it’s important to understand the pros and cons involved. Below are some of the advantages of stock warrants, as well as some downsides to be aware of.
- Depending on the stock price, a warrant may allow an investor to purchase a company’s stock at a discount.
- Warrants often have expiration dates years into the future, giving an investor flexibility as to when they choose to exercise.
- Because a warrant doesn’t require an investor to exercise, the most an investor can lose is the price they paid for the warrant, which is usually a small amount.
- When a warrant comes attached to a convertible bond, the investor will earn fixed-income interest payments until they exercise the warrant.
- If the company’s stock price doesn’t increase above the warrant’s strike price, then the warrant is worthless, and the investor could be out the money they paid for it.
- Depending on the current market price of the stock and the amount of time before the expiration date, an investor may have a difficult time reselling a warrant they don’t want to exercise.
- A warrant holder doesn’t actually own the stock or have any of the benefits of a shareholder until they exercise the warrant.
The Bottom Line
A stock warrant allows an investor to purchase shares of a company’s stock within a certain time period at a designated strike price. When the strike price in the contract is lower than the stock’s current market price, the investor can purchase the shares at a discount.
Because a stock warrant is a type of derivative, it’s considered a more advanced investing strategy that may not be right for new investors. A situation in which you may be likely to encounter a warrant is if you purchase a convertible bond which allows you to convert the bond you hold into shares in the company. This scenario enables you to benefit from its success in the long term.
As with any type of investment, it’s important to do your research before getting started with stock warrants, and consider how they’ll fit into your overall portfolio. The most important characteristics of a warrant are the underlying stock, the expiration date and the strike price.