Definition of Stock Warrants

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Most investors don't know much about stock warrants, which can be good investment opportunities. Warrants are similar to options in that they give the investor the right to buy or sell a stock at a set price but have some advantages. The savvy investor who takes the time to learn about stock warrants can add this investment vehicle to his repertoire and earn substantial profits.

Identification

  • A stock warrant is a derivative that guarantees the holder a specific price (called the strike price) for a certain number of shares of common stock until the warrant expires (called the expiry date). Warrants either give the investor the right to buy the stock at the specified price (a call warrant) or to sell it at a specified price (a put warrant). Common stock warrants are valid for much longer periods than options (up to 15 years).

History

  • Stock warrants first appeared in the 1920s. They are issued by the corporation issuing the underlying stock, rather than by a separate financial institution as in the case of options. Companies issued warrants along with bonds or new stock issues in order to lure investors. By the post-World War II era, warrants were popular enough that at least one financial newsletter, the RHA Warrant Survey, published regularly during the 1950s and 1960s. The advent of options trading captured the attention of the investing public, but stock warrants remain an important investment vehicle for institutions.

Function

  • The key feature of stock warrants is that they offer a way to leverage stock purchases. The extent of leverage is called the gearing ratio. If you buy call warrants for $5 with a strike price of $10 and the stock is selling for $15, the gearing ratio is 3:1. If the stock rises to $20, an investor who bought the shares outright makes a 33 percent profit. However, if you purchased warrants, the profit of $5 per share doubles the money you invested in the warrants---a 100 percent return.

Features

  • One feature of warrants that is confusing to some beginners is that it often takes several warrants to buy one share of stock. Exactly how many is called the conversion ratio. If the conversion ratio is 4, multiply the price of the warrant by 4 to see how much money you need to buy warrants for a single share of stock, and know how much leverage the warrants give you. Investors also must be aware that some European stock warrants can only be exercised on the expiry date. In the United States, warrants can be exercised at any time on or before the expiry date.

Considerations

  • Like any investment, stock warrants have disadvantages as well as advantages. You don't actually purchase the stock, so you have no voting rights and receive no stock dividends. Another factor is that, while warrants offer the chance of high returns, they also carry greater risk. If the stock falls below the stock price (or rises above it for a put warrant), the warrant is effectively worthless. How good a warrant is depends on the underlying security. The company whose stock a warrant represents should be thoroughly researched, particularly with regard to its fundamentals and future prospects.

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