Trading warrants is one of the lesser-known investment tools, but for experienced traders, they can be lucrative as they offer leverage on the price of an asset, such as a stock. Trading warrants relies on the underlying asset being above or below a certain price at a specific time and can offer numerous benefits to both the issuer and the investor. This guide will highlight the key features of trading warrants, including how to use and buy stock warrants, plus the benefits and risks. We also list and compare the best online brokers for trading warrants in 2023.
Warrants Explained
A warrant is an investment tool that allows traders to buy a security (usually company stock) at a fixed price, known as the ‘exercise’ or ‘strike’ price. This means investors can obtain newly-issued stock up until a pre-agreed date, known as the ‘expiration date’.
Once a warrant is purchased, it can be exercised by the holder, which is when the holder buys a number of shares of stock that are going to be created by the company, known as ‘underlying stock’. When a stock warrant is exercised, the stock is bought at the price set when the warrant was purchased. A warrant must be exercised before its expiration date.
Warrants are issued by companies because it often makes their stock more appealing to investors; if the price of the stock rises on the market, the warrant holder is still able to buy it at the strike price.
This attracts more investors to the company, while also benefiting the investor.
Importantly, the point is to purchase a warrant when you expect the value of the company’s stock to increase beyond what the warrant was purchased for. When this happens, the warrant can be exercised and shares of stock can be bought for less than their current trading price.
Warrants offer dilution by nature; they dilute the value of equity in shares when the new shares are issued. This may seem like a drawback, but it still allows good investments to be made when stock can be bought at a lower price.
Key Information
New investors often ask the question: how do warrants work in practice?
Well firstly, the investor buys a warrant when it is issued by a company, thereby giving them the right to purchase company stock up until the expiration date of the warrant. When a holder tells a company (the issuer) that they are going to buy underlying stock, a warrant is exercised. The company then issues new shares of stock, so the overall number of outstanding shares increases.
Here are some of the key things to keep in mind when it comes to trading warrants:
- Purchasing a warrant does not give the investor ownership of anything, only the right to buy or sell stock with warrants in the future.
Investing in a warrant does not give you shareholder and voting rights or allow the collection of dividends.
They are best suited to medium to long-term investments, and as a tool, they are both high risk and high return.
For private investors, warrants work well because their cost is typically low, and the investment that is required to acquire a lot of company equity is small.
Warrants work differently depending on the country you are in, so there will be different terms and rules for different products worldwide.
For example, in the US investors can typically exercise a warrant any time up until the expiration date, whereas in Europe the expiration date is typically the only day that the warrant can be exercised.
The ‘premium’ of a warrant refers to the difference between the current price of a warrant and its minimum value.
The minimum value of a warrant is the difference between its strike price and the current price of underlying stock.
The ‘conversion ratio’ refers to the number of warrants needed to buy or sell one stock.
For example, if the conversion ratio is 5:1, then the holder needs 5 warrants in order to purchase 1 share.
Example
Seeing a real-life example is key to understanding how they actually work, as well as showing how they can be a lucrative investment.
A good example of success is Warren Buffet, who made a $5 billion investment in Bank of America using warrants in 2011.
Buffett’s company, Berkshire Hathaway, was able to buy 700 million common shares of Bank of America stock at $7.14, and due to the use of warrants was able to exercise them at any time before the year 2021.
At the time of the deal, the stock was trading at around $7, so the warrants were not worth a lot; to exercise the warrants in 2011 would have been a poor investment.
By 2017, however, Bank of America stock was trading at around $25, prompting Buffett to exercise the warrants.The total payout from exercising the warrants was $12 billion.
This example shows how they can be strategically exercised by waiting for long periods until the stock is trading at a preferable price.
Types
There are two key types of warrants: put and call.
With put warrants, holders are able to sell shares of stock that they already own, while with call warrants, investors are able to buy shares of stock.
- Call – The majority of warrants are calls, allowing holders to buy stock at a preset strike price before the set expiry date.These can then be exercised when the stock’s market price is higher than the stock warrant’s exercise price.
- Put – Put warrants allow a holder to sell shares back to the company at the strike price.These can be exercised at the strike price and are best used when the market price is lower than the strike price.
These are the two main classes for trading warrants, but the full list is far longer, including:
- Wedded – Wedded warrants remain attached to a bond, so when a warrant is exercised by the holder to gain their shares, they will lose the bond as well.
- Covered or naked – Covered warrants are issued by financial institutions rather than companies.
With covered products, the exercising of the warrant does not result in new stock being issued. Instead, the institution that owns the underlying stock covers the warrant.
You can also trade the following types of warrants:
- International equity
- International index
- Equity knock-out
- Commodity
- Currency
- SPAC
- Turbo
Why Do Companies Encourage Trading Warrants?
Companies issue stock warrants to attract investors and gain more capital. For young companies and startups, this can be effective and necessary in the early stages of starting a business. When a company issues shares, it can also issue warrants which give investors the opportunity to buy shares at a lower price in the future. This process is known as ‘attaching’ warrants to stocks and bonds.
For young companies, there might be an expectation from prospective investors that they would attach warrants to stocks and bonds to offer protection against the risk of investing in a new or small company.
Companies may also issue stock warrants when trying to raise capital for a specific project or undertaking, or when they are facing bankruptcy. They can also be added to bonds to make them more attractive to investors and reduce the interest paid to bondholders.
For the issuer, warrants give them the opportunity to make money twice.
The first time is when the warrant is bought, as they collect a fee from the investor, and the second is when the investor uses it to purchase stock, whereby the company takes money from the sale of the shares.
How To Exercise
Warrants appear in your trading account the same way that options and stock do. It is best to exercise your warrant through your online broker – they are going to handle the communication between yourself and the company issuing the warrant. You can contact your broker and let them know you want your warrants to be exercised. During this conversation, state how many you would like to exercise, and your broker will contact the company. After this, the warrants will no longer be in your account and the stock will appear in their place. Some trading platforms also facilitate orders directly on their platform.
The time to exercise a warrant is typically when the current price is above the strike price of the warrant. The alternative to exercising your warrant is to sell it. You probably don’t want to exercise the warrant if the current price is below the strike price, because it would be cheaper to buy the security on the open market. During this time, the strike of the warrant would be higher than what the security is being traded at, so to exercise the warrant would be to buy the asset at a higher price.
To conclude, investors should exercise a warrant when the security is trading at a higher value than the strike of the warrant, because you are getting the asset at a better value.
However, the asset price being higher than the warrant strike does not mean that the warrant needs to be exercised, and if there is still time before its expiry, you can wait until there is a better time to exercise it.
Strategy
There are many strategies for trading warrants, but whatever approach you choose to employ should ensure that you are minimizing risk. Here are some of the key ways to be strategic:
- Using charts and patterns – These are used to predict how prices may vary in the future, working on the assumption that patterns that have happened before will happen again. It is wise to use the best indicators for trading options for your particular strategy, but generally speaking, Bollinger Bands, Money Flow Index, Relative Strength Index and Open Interest are all good choices.
- Make sure your timing is right – This is true of the timing of trading itself, but it’s also a good idea to make sure you are setting up for trading at the optimal time of the day. Follow major US and European trading windows to judge how the market is behaving.
- Educate yourself – Use various resources so that you know as much about trading warrants as possible. This is how you are going to develop better insight into market changes. Resources can be anything from books and courses to blogs and videos. The top warrant brokers also offer a good selection of training materials.
Note, you can start trading stock warrants on several leading brokers and websites, including eTrade, WeBull, TD Ameritrade, Fidelity, Trading 212, Charles Schwab, Vanguard, Robinhood and Interactive Brokers.
Many of these firms also offer warrant screeners with helpful search functions and symbols.
Pros And Cons
Let’s also look at the good and bad of investing in warrants:
Advantages
Although trading warrants is high-risk, they can also offer high-rewards, and there are many advantages that investors can gain from trading warrants vs stocks.
The main advantage of purchasing a stock warrant is that warrant prices are lower than the prices of current stock being traded on the market.Because of this, they can be leveraged too – this means both the potential gain and loss are going to be larger.
For example, if a share was quoted at $2.00 per share, an investor would need $2,000 to purchase 1,000 shares.However, if the investor bought a warrant that represented one share and was priced at $0.50, then with the same capital, 4,000 shares could be bought.Therefore the opportunity to make much larger gains is awarded to those investing using warrants.
Disadvantages
Like any kind of investment, warrants come with risks.While there are advantages to how warrants can be leveraged, the same mechanisms that make this possible also have drawbacks for investors.
If we look at the above example in reverse, i.e.the share price dropped, then the opposite occurs for the investor.
This means that if the share price drops, then the percentage loss for the share price is going to be far smaller than the loss on the warrant.
Furthermore, if the value of the certificate drops to 0 and the warrant hasn’t been exercised, then the warrant loses redemption value entirely.
The final disadvantage of warrants is that a trader is not a shareholder and does not have the power to vote or to dividend rights, so they get no say in how the company is run, and yet are still at risk of being impacted negatively by the decisions that are made within the company.
How To Value Warrants
Warrants lose their worth if the market price of the stock falls below the strike price, and this is also the case if the stock warrant expires.Therefore, the value of warrants is determined by the market.The intrinsic value of a warrant is equal to the difference between the market price and the strike price of the asset or stock.Time comes into this too, as securities may become more valuable before the warrant expires.
This means, however, that warrants do not have any intrinsic value when they are issued, as their strike price is above the current market price when they are delivered.This is why they often come with longer periods before they expire, to allow for the asset’s price to surpass the strike price and create the warrant’s intrinsic value.
To value a warrant, find the current price of the security on the market.You can do this by using a stock warrants calculator and the formula below.
Subtract the strike price from the market price, and you will find the intrinsic value of your warrant. Then, divide the intrinsic value by the number of shares that can be purchased with one warrant. The formula is as follows:
(current price – subscription price) / warrants needed
For example, if the market price is $100, the exercise price of a warrant is $80, and the amount of shares that can be bought with a warrant is 1, the value can be found by calculating ($100 – $80)/1 = 20.
Tax Treatments
The issuer does not incur any tax implications for issuing warrants, but there are consequences for the transfer, holding, exercising and selling of the products that can have an effect on your takeaway from an investment. It is important to be familiar with the tax implications of trading warrants before you begin investing.
Consult a local tax advisor for guidance. Note, taxes may also vary depending on your location, for example, if you are in Canada versus Australia, Malaysia, the UK or the US.
What Is The Difference Between Warrants And Options?
Warrants and options are different, but they do come with some similarities. Both allow the opportunity to buy or sell assets at a preset price and are given an expiration date whereby this can happen. They both have strike prices and expiration dates, and both allow investors to leverage them by agreeing upon a price for the future known as a ‘premium’.
A final similarity is that they are both best exercised when the price is higher or lower than the strike price, depending on if it’s a call or a put.
However, there are also differences. While warrants are normally issued by a company, options are traded in the secondary market and created by market participants. The contracts for options are also a lot shorter than they are for warrants. While the contract for a warrant can be as long as 15 years, the expiry on an option is usually less than one year, and can be as short as a few days.
Another important difference is that warrants often raise capital for companies and bring in new investors, but options do not.
Final Word On Trading Warrants
Warrants certainly have their upsides for investors, but if you are investing then it’s important that you are in the know about the current state of the market. The use of warrants is only recommended for those with the ability and skill to avoid the pitfalls, as well as for those who have an effective trading strategy. For this reason, it can also be beneficial to consult with a financial advisor or broker prior to adding warrants to your portfolio.
To conclude, seeing as warrants are not used as widely as other investment options, they can still be a great way to make smart and educated investments that can pay off. See our list of supporting brokers to get started today.
Further Reading