What Are Stock Warrants?
A stock warrant is a type of contract that gives investors the right to buy or sell shares of a company at a specific price.
Although derivatives can help diversify a portfolio, retail investors should be very careful about how they are used and their exposure to risk.
Understanding Stock Warrants
A stock warrant is a type of derivative contract that allows an investor to buy or sell shares of a public company at a specified price.
Like options contracts, warrants have a strike price. This price is the price at which the investor can buy or sell the shares.
When exercised, the warrants give the holder the right to purchase one share of the company. However, since the exercise price is dilutive to the existing shareholders, the company issues more shares.
Though you receive the shares directly from the company, they can be held in a normal account with an online broker.
Types of Warrants
Put and call warrants are two different types of warrants. The former allows investors to sell their shares while the latter allows them to buy them.
Most call warrants are issued for a specific period, which can end on the date that the contract has its expiration.
For instance, if the stock price is $150 and the strike price is $110, the investor should exercise the call and get a $40 discount if they buy one share of the company's stock.
The holder of a put warrant is not obligated to sell the shares at the strike price. However, they can liquidate their shares at any time.
Other Aspects of Warrants to Keep in Mind
All warrants are classified based on their expiration date. In the US, European warrants can only be exercised on the date that the contract has its expiration.
A conversion ratio, which is also known as the number of warrants required to buy one share, indicates the number of warrants that are needed to purchase one share.
Why Do Companies Issue Warrants?
If a company needs to raise capital, it usually sells warrants to raise funds. Proceeds from the sales go toward increasing the company's capital.
This type of transaction also encourages the purchase of bonds or preferred stocks. With warrants, investors can benefit from the rising share prices when the conversion threshold gets reached.
The purpose of warrants is to attract and retain employees. In most cases, these contracts are usually linked to pay increases and are usually granted several years in advance.
Warrants and Taxes
Unlike shares, holders of warrants do not enjoy the tax advantages that are usually associated with employee compensation.
When exercised, the warrants are considered capital gains, which are taxed as ordinary income. Since the holder of these contracts doesn't own shares in the company, they are taxed as ordinary income.
Warrants vs. Options: What’s the Difference?
Regardless of the type of contract, both options and warrants give investors the ability to buy or sell assets at a price they agree with.
With warrants and options, investors can get leverage by locking in a future price for a certain amount of money. They can use it to purchase or sell stocks at a certain price regardless of the current market price.
Unlike options, warrants are issued by a company. They can be used to generate income or to hedge positions in other assets.
Both options and warrants are usually short-term contracts. However, they can also be used for a long time.
When exercised, the new stock issued by the company is dilutive to the existing shareholders.
The Bottom Line
While many people benefit from the derivatives market, they are also prone to making mistakes. This is why it is important to seek the advice of a financial advisor before committing to these instruments.