Stock Warrants

A small outlay controls a much larger slice of equity!




Stock warrants, like options, give the holder the right but not the obligation to buy an underlying security (typically a specific number of shares) at a certain price, quantity and future time.

Unlike an option that is a stock-exchange product, a warrant is issued by a company.

The shares are delivered by the issuing company instead of an investor holding the shares.


Types of Warrants

There are a number of different types of warrants. Stock warrants (or equity warrants) can be call and put warrants.

Call warrants give you the right to buy the underlying stock. Put warrants give you the right to sell the underlying stock.

The former represents a specific number of shares that can be purchased from the issuer at a specific price, on or before a certain date.

The latter represents a certain amount of equity that can be sold back to the issuer at a specified price, on or before a stated date. Both types have a specified expiration date.

A covered warrant has some underlying backing. The issuer may purchase the stock beforehand. Index warrants use an index as the underlying asset.

Traditional warrants are issued in conjunction with a bond (referred to as a warrant-linked bond). This gives the buyer the right to acquire stock in the entity issuing the bond.

Naked warrants are issued without a bond and like traditional warrants are traded on a stock exchange. They are also referred to as covered warrants and are generally more popular than traditional warrants.


Buying and Selling Stock Warrants

The exercise price or strike price is the amount that must be paid in order to either buy the 'call' variety or sell the 'put' variety.

The payment of the strike price results in a transfer of the specified amount of stock.

The conversion ratio is the number needed in order to buy (or sell) one share. If the conversion ratio to buy a particular stock is 4:1, this means that the holder needs four in order to purchase one share.

Usually, if the conversion ratio is high, the price of the share will be low, and vice versa.


Valuing Warrants

The market value of a stock warrant is composed of two components ...

  • Intrinsic value - which is the difference between the exercise (strike) price and the underlying stock price. If the stock price is below the strike price, the stock warrant has no intrinsic value - only time value. It is 'out-of-the-money'. If the opposite situation exists, the warrant has intrinsic value and is 'in-the-money'.
  • Time value - can be described as the value of the continuing exposure to the variation in the stock that the warrant provides. Time value declines (referred to as time decay) as warrant expiration approaches. The longer the time to expiry, the greater the time value of the warrant.
The more volatile the underlying stock price is, the higher the price of the warrant will be, as the warrant is more likely to end up 'in-the-money'.

Weighing up these two influences allows the investor to form a view as to the value of an investment.


Advantages

Stock warrants are transferable and tend to be more attractive for medium-term to long-term investment plans. They are high risk, high return investment tools.

They are also an attractive option for speculators and hedgers. This is because the cost is commonly low, and the initial investment needed to command a large amount of equity is quite small.

In some countries, investors can include warrants in do-it-yourself superannuation portfolios in order to gear the portfolio.


An Example

As an example of one of the potential benefits of this type of security, say that a particular stock is currently priced on the market for $1.50 per share. In order to purchase 1,000 shares, an investor would need $1,500.

However, if the investor opted to buy a warrant (representing one share) that was going for $0.50, with the same $1,500, s/he would possess 3,000 shares instead.


Disadvantages

Because of the low price, the leverage and gearing that warrants offer is high. This means that there is a potential for larger capital gains - and losses!

A disadvantage and risk to the investor is that the value of the certificate can drop to zero. If that were to happen before it is exercised, the warrant would lose any redemption value.

Also, a holder usually does not have any voting, shareholding or dividend rights.

The investor can therefore have no say in the functioning of the company, even though s/he is affected by any decisions made.


To Conclude

Warrants involve making a judgement on the movement of the underlying stock price so may appear to be a speculative endeavor. However, the lifetime of a warrant is measured in years, whereas options are typically measured in months.

So from a value investing perspective, value investors may be comfortable with warrant investing if they can value the underlying stock to their satisfaction and they are comfortable with the type of gearing that accompanies warrant investing.


As a value investor, do I use warrants? No, because I find that having margin loan is more straight forward in terms of tracking my gearing ratio over the whole portfolio.

The related article below examines in more detail the importance of understanding gearing.


Related Article

Margin lending - allows you to use the equity in your stock portfolio to borrow money to buy more stocks.



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