What Is a Stock Warrant?
A stock warrant is a derivative similar to an option in that both allow you to buy the underlying security at a specified price. Warrants don't have the high profile in financial circles that options do, but are frequently held and traded by institutional investors as a hedge to protect money invested in the underlying security. Warrants have a longer lifespan than options---up to 15 years. There are other important differences that the investor interested in stock warrants should know.
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Identification
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A stock warrant gives the holder the right to buy a specific number of shares of a stock at a set price called the strike price until the date the warrant expires. However, warrants are issued by the corporation whose stock the warrant represents rather than through a stock exchange like options. When a corporation issues new stock or bonds it will often issue warrants as well as an incentive to investors.
Types
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Companies can issue two basic kinds of warrants. A call warrant entitles the investor to buy the stock at a specific price. A put warrant effectively guarantees a minimum price by enabling the investor to sell the stock for a specified price at any time up to the expiration date. Terms on warrants vary. In America an investor can usually exercise the warrant (use it purchase the stock) at any time on or before the expiration date. In Europe you may only be able to exercise the warrant on the date of expiration. Warrants are sometimes issued for other securities, including indexes, commodities and currency.
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Features
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Stock warrants enable you to leverage a stock. This is expressed by the gearing ratio, which is the ratio between the money required to buy the warrants and the price of the stock. If you purchase warrants worth $2 that give you the right to buy a share of stock worth $10, the gear ratio is $10 divided by $2 or five to one. This means you can make five times as much profit for a given investment. One feature of warrants that has to be kept in mind is the conversion ratio. This refers to the number of warrants you need to buy one share of the underlying stock. Normally it takes several warrants to buy one share, so you have to multiply the price of the warrant by the conversion ratio to see how much you need to invest. If the conversion ratio is four to one and the warrant is $0.50 will need to invest $0.50 times four, or $2.00 to have the warrants needed to acquire one share of stock.
Function
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If you buy a stock for $10 and it goes up to $12, you have a gain of $2 per share, or 20 percent. However, if you buy warrants for the same stock for $2 then the value of your warrants will then be $4---you've made a 100 percent profit. At this point you can sell the warrants or you can choose to use them to buy the stock at the strike price. If you do choose to exercise the warrant, you have to pay the premium. This is the difference between the value of the warrants and the strike price the warrants entitle you to. Doing this is as simple as other transactions since your broker will handle the paperwork, which is quite complicated. All you need to do is take the warrants to your brokerage and let them handle it from there.
Considerations
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Warrants are a type of security that carries high risk as well as the possibility of large gains. If a stock declines below the strike price, the warrants are worthless and you can lose all of your money. On the other hand, that's the limit of your risk. Your potential gains are unlimited. There are some other things to keep in mind. First, warrants have a limited life. This is usually years, so it may not be a concern but you should know the expiration date---if you don't sell or exercise warrants before the expiration date, they lose their value. You don't actually own the stock, so you cannot receive dividends or vote at shareholders' meetings.
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