Warrants: A Risky but High-Return Investment Tool

A warrant is similar to an option, giving the holder the right but not the obligation to buy an underlying security at a certain price, quantity, and future time. The security represented in the warrant is usually share equity and is delivered by the issuing company rather than a counterparty holding the shares. A warrant can also increase a shareholder's confidence provided that the underlying value of the security increases over time.

A warrant is unlike an option in that it's issued by a company. An option is an instrument offered by a central exchange, such as the Chicago Board Options Exchange (CBOE).

Types of Warrants

There are two types of warrants: call warrants and put warrants. A call warrant represents a specific number of shares that can be purchased from the issuer at a specific price on or before a certain date. A put warrant represents a certain amount of equity that can be sold back to the issuer at a specified price on or before a stated date. Warrants are just one type of equity derivative.

Characteristics of a Warrant

The warrant certificate includes disclosures about the security's characteristics and the holder's rights or obligations. All warrants have a specified expiration date, the last day the rights of a warrant can be executed.

Warrants are also classified by their exercise style. An American warrant can be exercised anytime before or on the stated expiration date. A European warrant can be exercised only on the expiration date.

The certificate also includes detailed information on the underlying instrument. A warrant typically corresponds to a specific number of shares but it can also represent a commodity, index, or currency. The exercise or strike price states the amount that must be paid to buy the call warrant or to sell the put warrant. The payment of the strike price results in a transfer of the specified shares or value of the underlying instrument.

The conversion ratio states the number of warrants that are necessary to buy or sell one investment unit. A call warrant might state that the conversion ratio to buy stock XYZ is 3:1. The holder would need three warrants to purchase one share.

The share price will typically be low if the conversion ratio is high and vice versa. An index warrant carries an index multiplier rather than a conversion ratio with that number used to determine the amount payable to the holder on the exercise date.

Investing in Warrants

Warrants are transparent and transferable certificates that tend to be more attractive in medium- to long-term investment schemes. These high-risk, high-return investment tools remain largely unexploited in long-term strategies but they offer an attractive alternative to speculators and hedgers.

Warrants offer a viable option for private investors because the cost of ownership is usually low and the initial investment necessary to command a large amount of equity is relatively small.

Advantages of Warrants

Let's say that XYZ shares are currently quoted at $1.50 per share. An investor would need $1,500 to purchase 1,000 shares at this price. But 3,000 shares could be controlled with the same amount of capital if the investor opted to buy an XYX call warrant representing one share that was priced at $0.50.

Warrant prices are typically low so the leverage and gearing they offer are typically high. This can generate potentially larger capital gains and losses. It's common for share and warrant prices to move in tandem in absolute terms but the percentage gain or loss will vary significantly because of the initial price difference. Warrants tend to exaggerate the percentage change movement compared to the share price.

Another Example

Now let's say that XYZ shares gain $0.30 from $1.50 and close at $1.80, generating a 20% gain. The warrant gains $0.30 at the same time, rising 60% from 0.50 to $0.80. The gearing factor is calculated by dividing the original share price by the original warrant price: $1.50 / $0.50 = 3. This denotes the general amount of financial leverage that the warrant offers. The higher the number, the larger the potential for capital gains or losses.

Warren Buffett's Berkshire Hathaway made a deal to invest in Bank of America, acquiring warrants for BAC common stock at an exercise price of $7.14 each, paying roughly $5 billion. The stock eventually rose to $24.32 per share, allowing the Oracle of Omaha to exercise those warrants for more than $17 billion, reflecting a $12 billion gain on the original investment.

Disadvantages of Warrants

Warrants also have drawbacks and risks just like any other type of investment. The leverage and gearing that warrants offer can be high but these can also work to an investor's disadvantage.

Let's reverse the outcome of the XYZ example and realize a drop in share price by $0.30. The percentage loss for the share price would be 20% in this case. The loss on the warrant would be 60%. Leverage can be a good thing up to a point. The value of the certificate can drop to zero, presenting another disadvantage to the warrant investor. The warrant would lose any redemption value if it happens before it's exercised.

A warrant holder has no voting, shareholder, or dividend rights and has no say in the function of the company even though they're affected by the company's decisions and policies.

The Bottom Line

Warrants can be a useful addition to a traditional portfolio but investors should be attentive to market movements due to their risky nature. But this largely unused investment alternative offers the opportunity to diversify without competing with the largest market players. What's true for warrants is true for options.