Stock Options & Warrants
Stock options and warrants are wasting assets that confer the right, but not the obligation, to purchase stock for a fixed price during a predetermined period of time. Due to their expiration dates, they are considered wasting assets because the time value of the option or warrant evaporates as the expiration date draws near. If the strike price (the fixed purchase price of the option or warrant) is below the market value of the stock on the expiration date, the option or warrant will expire worthless.
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Function
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Stock options are exchange-traded contracts that offer expiration dates for every month of the year. Stock options expire on the third Friday of the month they represent. Each stock option represents 100 shares of the underlying stock, so they function as a leverage tool, among other things. They give investors the right to purchase 100 shares of stock for a predetermined price, called the strike price. If the strike price of a given call option is below the current price of the stock, the option holder can either exercise the option and purchase 100 shares of the stock at the lower price, or he can sell the option for a profit.
Warrants are similar to stock options with a few critical differences. First of all, they are typically longer-term than options. When a company issues warrants, the warrants usually don't expire for several years. Also, companies issue warrants to raise capital, where options trading in a company's stock doesn't benefit the company financially at all. Often, warrants are issued during an initial or secondary public offering. A common structuring will be two shares of common stock and one warrant packaged as a unit and sold to the initial investors. The warrants become free trading after the offering. Another critical difference is that warrant expiration dates can be extended with board approval.
Types
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The two types of stock options are calls and puts. Calls are purchased when an investor believes the price of the underlying stock is going to rise. Puts are purchased when an investor believes the price of the underlying stock is going to fall. Warrants only confer the right to buy the stock, while a put option technically confers the right to sell the stock.
Time Frame
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Investors always need to be aware of expiration dates when buying and selling stock options and warrants. These financial instruments are comprised of two value components. The time value represents the remaining period of time between a given date and the expiration date. The intrinsic value of a stock option or warrant is the difference between the strike price and the stock price. If the stock price is lower than the strike price, the option has no intrinsic value. If the stock price is higher than the strike price, the difference in the prices is the intrinsic value.
Size
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Another important difference between stock options and warrants is the leverage they provide. While stock options represent 100 shares of stock per option, warrants only confer the right to buy one share of stock per warrant.
Warning
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Trading in stock options and warrants is a high-risk activity. They can be extremely volatile. As they near their expiration date, their time value declines at an accelerated rate. If they have no intrinsic value, they can be completely worthless long before they actually expire.
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