Investing in warrants can provide investors with a valuable alternative to common stocks, so what is a warrant?
A stock warrant provides the holder with the right, but not the obligation, to buy a specified number of shares at an exercise price before an expiration date. Consider this example: JPMorgan, the global financial services company, has a warrant that allows a holder to buy one share of JPMorgan common stock at $41.967 per share that expires on October 28, 2018. The warrant trades under the symbol “JPM.WS” on the New York Stock Exchange. The holder can buy one share of JPM common stock for $41.967, regardless of the market price of the common stock, anytime up to October 28, 2018.
Warrants are very similar to options, with a few important differences:
- Warrants are issued by the underlying company. When exercising a warrant, the holder buys newly issued shares from the company. Options, however, are exercised into existing shares already being traded.
- Warrants are traded on stock exchanges, whereas options are traded on options exchanges.
- Warrants generally have longer lives, in some cases 10 years. Options generally have shorter lives, with most options expiring in less than one year.
- Warrants provide some dilution protection. When a company pays a dividend, its share price is adjusted downward by the amount of the dividend. For most warrants, the warrant exercise price is similarly adjusted downward. The JPMorgan warrant originally had a $42.40 exercise price, but due to dividends paid over time, now has a $41.967 exercise price. The exercise price on options, however, does not change.
Like options, warrants are not equity. They only convey the right to buy equity. As such, neither holder is entitled to dividend rights, pre-emptive rights, proxy voting or any share of any liquidation.
Warrants are often issued as an incentive for investors to purchase newly-issued company securities. While high-quality companies including many banks have issued warrants, smaller and higher-risk companies (and unfortunately some companies of questionable quality) may offer warrants to entice potential purchasers of their bond or stock issuances.
How do warrants work? Warrants allow the holder to benefit from the change in value of the common stock without putting up the capital for the full value of the stock. Using the JPMorgan warrant as an example:
- With its $41.967 strike price, the warrants allows a holder to buy one share of JPM common stock at $41.967. If JPM shares were trading at $50, the warrant would trade at about $8 (or, 50 less 41.967). If the stock rose to $55, the warrant would increase to about $13, for a 62.5% return (a $5 gain on the $8 price). This would compare to the 10% return on the stock.
- Moves in the opposite direction have the same magnified effect, only in reverse. A drop in JPM shares to $45 from $50 is a 10% decline. But the warrants would fall to somewhere around $3, for a negative 62.5% return.
Here is a more aggressive example: Suppose biotech company XYZ issues warrants allowing the holder to buy one share of XYZ common at $10 that expires in 2021. The common stock is trading at $6 per share. The warrant has little value, trading at perhaps $0.50 per warrant. However, if the company has a promising drug that then receives government approval, driving its common stock to $11 (for an 83% gain), the warrant would increase in value to perhaps $12, for a 24x return.
So, investors can use warrants for at least two purposes:
- The combination of price leverage and relatively long life makes them attractive for those investors who are willing to take on more risk to obtain potentially higher returns.
- For capital-constrained investors, they can offer cheaper exposure to a company, as only the warrant price needs to be funded, not the entire price of the common stock.
While their return potential can be very high, warrants also carry significant risks:
- Warrant prices can be highly volatile until the common stock price is well-above the exercise price. A holder can both increase and lose significant amounts of their investment.
- Warrants expire worthless unless exercised or sold prior to their expiration date.
- Investors can lose money on warrants even if the common stock price goes up, particularly if the common stock price is well-below the exercise price.
Warrants provide a valuable tool for the savvy investor. When selected and implemented well, they can be a smart addition to a diversified investor’s portfolio.
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