How to Buy Stock Warrants
Stock warrants are a great way to invest in a company when you don’t want to pay the full cost of the common stock.
Warrants provide leverage, much like an option, when you know how to purchase stock warrants on companies that have an outstanding warrant. This will magnify your returns if the stock moves up, and can even limit your losses when the stock moves down.
Warrants trade on stock exchanges, just like a stock, and do not need a special account. They do not require you to sign any additional paperwork, like you have to when you trade options.
Warrants vs. Stock Options
Warrants let the owner convert the warrant into stock of the company at a specific price, the exercise price, for a predetermined amount of time. They are similar to call options.
For example, insurance company AIG has warrants (NYSE: AIG.WS) which are currently exercisable at $43.475 per share. If you own one warrant, you can instruct your broker to exercise the warrant, and for the warrant, plus $43.475, you will get one share of AIG common stock.
As AIG issues dividends each year, the exercise price, the amount of money you need to add to your warrant, decreases. And, the number of shares you receive for your warrant increases. In this way you benefit from the dividend issued by the company, even if you don’t actually get the dividend as a payment in your account they way you would if you owned the stock.
This makes the warrant better than a stock option. As the company issues dividends the warrant becomes more valuable. This is one of the ways warrants can be different than options.
Owning a call option gives you the right, but not the obligation, to buy a common stock at a given price, the strike price, for a predetermined amount of time. Purchasing a stock warrant will give you the same right, but there are some differences between warrants and options.
- Warrants are usually longer term than stock options. Stock options with 2 year expiration dates are called LEAPS. A warrant can have a much longer expiration date, but most expire in a two-five year time period. Some have longer expirations (the AIG warrants will have a ten year period before expiration), and the company can even extend the expiration period if it wants.
- The reason a company can extend the expiration period is because warrants are issued by the company, not by an exchange the way options are. Options give you the right to buy shares from the open market. If you exercise warrants the company must have stock it has registered for the purpose of converting the warrants to common. The company then gives you shares of common stock for your warrants.
- As discussed above, many warrants have an anti-dilution clause. This protects the investor from losing value when the company pays a dividend, and in some cases when a company issues additional stock. A warrant is given protection by adjusting the exercise price, the number of shares received upon exercise, or both. This makes warrants with similar expiration times to options more valuable than a call option.
How Warrants Work
Let’s look at a specific example of how a warrant works in order to see how it can be better, or in some cases worse, than owning the common stock.
For our example we’ll use the fictional company name of Aunt Betty’s Blockchains. Aunt Betty is a wiz at coding and has come up with a use for her blockchain that you think will revolutionize cookie baking. You can securely track calories and never change them on your calorie tracking spreadsheet, 😉
Aunt Betty’s Blockchains trades on the stock exchange for $30 per share and has warrants that are exercisable at $25 per share. The warrants are exercisable for the next 5 years, and currently trade at $8 on the exchange (remember, warrants trade just like stocks). So…
- Current stock price: $30
- Current warrant price: $8 ($5 of intrinsic value, and $3 of extrinsic value, or time value)
- Warrant exercise terms: $25 exercise price for 5 years
Now let’s see if you hold the warrant to expiration whether or not you would be profitable. We’ll look at a few different scenarios, but to be profitable you need the warrant to trade above $33 at expiration in 5 years. This would make your warrant worth more than $8.
If the stock is trading at $40 in 5 years, the warrant will be trading at $15 right at expiration. This means that the stock will have gained 33%. Your warrant, which you bought for $8, will have increased in value by 87.5%, a much higher gain.
But, if the stock is trading at $20 in five years it will have lost 33%. But, your warrant, which is exercisable at $25, will be worthless when the stock is trading at $20. So you will have lost 100% of the value of your warrant. Let’s look at a few price examples and what the gains and losses would be in 5 years.
[table id=1 /]You can see from the table that if the stock stays at the same price, or declines in price, you’ll lose a percentage of your investment in the stock, but lose the entire amount of your warrant investment. So if the stock stalls, or falls, you’ll lose much more, 100%, on a warrant investment. Of course you can sell the warrant before that happens.
If the stock rises, the warrant will outperform the stock price on a percentage basis, even if the stock rises only slightly. You can see that if the stock rises $5 in that 5 years you’ll make 8 more percent with the warrant than the stock. So the warrant provides leverage which works for you as the stock moves up, and against you as the stock moves down.
Why Invest in a Warrant vs. the Common Stock
You see the advantage you get when buying a warrant on a stock that moves up. You make a higher percentage return on your investment.
Warrants can also be used in a defensive manner, or to minimize risk. Let’s say I believe a stock like AIG, which has come down from almost $65 last year to trade at around $43, has bottomed and is now a buy.
If I have $1,000 to invest, I can buy, or control 23 shares of the stock with that $1,000. Or, with that same $1,000 I can control 133 shares of the stock, by purchasing the warrant at around $7.50. Alternatively, I can purchase fewer warrants. I can buy 66 warrants, which give me the right to buy, or control, 66 shares of common stock, and only pay $500.
Buy doing this I only put $500 at risk and control more stock. The warrant provides me with leverage. So I control more stock with less money.
I can also buy the stock warrants if I want to invest in AIG, but don’t have the capital to purchase the full allotment of shares I want in my portfolio. 100 shares of AIG right now would cost me over $4,300 to purchase.
If you anticipate receiving $4,300 over the next year, and want to place that in AIG stock, you can simulate the returns you hope to get from the stock starting today by only investing $750 now.
While warrants will take larger losses on a percentage basis as the stock drops, you can offset this risk by taking a smaller dollar position, and still control a large number of shares.
If you control at least 100 shares of the stock via the warrants you can also employ other strategies you might use if you owned the common stock outright, such as sell a call option against your warrants. As long as you have the proper capital in your account, a covered call is a great way to reduce the cost of your warrant investment even further.
Learn More About Warrants
If you’d like to learn more about warrants and how to use them to enhance your investment returns, you can check out a free video on one of the most profitable warrant trades around here.