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What are warrants?
What are warrants?
Warrants are one of the lesser known derivatives, at least on the American market, although they are common in Taiwan, Hong Kong, Germany, and other Asian and European countries. They are most similar to options, in that they give the owner the right, but not the obligation, to trade a security at a predetermined price
the date of expiry (in the U.S. only) or
the expiration date in European countries. There are both call and put warrants. Warrants are most commonly attached to equities, although they can also represent currency, commodities, or indices. Upon payment of the strike price, the underlying instrument is transferred to the new owner.
There are several important differences between options and warrants:
Warrants are usually issued by a company, as opposed to options, which are exchanged between two investors. The issuing company itself fulfills the obligation in the warrant.
Warrants are dilutive; in other words, the company issues new stock to fulfill them. Options deal with outstanding stock.
Warrants are generally traded OTC, while options trade on an exchange.
The expiry date for warrants is typically a period of years, up to 15, while options tend to expire in a period of months, with the maximum being 2 to 3 years.
There are no dividends or voting rights associated with warrants.
Companies issue warrants as a way to raise money. When options are traded, the company itself receives no money from the transaction.
Warrants can either be detachable or wedded; a detachable warrant can be separated from the underlying security and sold on the secondary market while a wedded cannot. A third type, naked warrants, are issued without any attached stock or bond. Financial institutions also issue warrants, known as covered warrants because the financial institution already owns the underlying security, i.e. it is “covered.” Covered warrants do not result in any new issue of stock. Warrants are highly leveraged instruments. For example, if ABC’s stock was currently trading at $6, an investor could buy call warrants for ABC stock at $2, representing leverage of 3:1. This is important, because while the price of shares and warrants tend to move the same amount in absolute terms, the
percentage of movement
is radically different, because it is based on the initial price of the instruments. For example, if shares of ABC increase from $6 to $7.50, it represents a gain of 25%. At the same time, ABC warrants also gain $1.50, from $2 to $3.50, representing a gain of 75%. Warrants have the potential for huge gains—and equally huge losses. Warren Buffett, the Oracle of Omaha, used warrants to make $12 billion over six years, a gain of over 200%, in a financing deal with Bank of America. In 2011, in the wake of the subprime mortgage crisis, Buffett’s Berkshire Hathaway bought warrants for 700 million shares at just over $7 each. In 2017, when the bank’s shares were trading at over $24, he exercised his warrants for $17 billion. Of course, the leverage works in reverse, as well. If ABC shares in the example above dropped to $4 from $6 before the expiration date on the warrant, the warrant itself would have no redemption value, i.e. the value would drop to zero.