Warrants and options can be confusing to investors. This means they miss out on potentially lucrative opportunities. Warrants and options which are often referred to as ‘stock warrants’ and ‘stock options’ are two terms you will probably come across on your investing journey.
In this article about warrants vs options, we will look at exactly what warrants and options are, their differences and help you choose which one to invest in. Stock warrants and stock options are both very popular because they provide investors with the potential to benefit from rising and falling share prices.
Warrants vs Options: key terminology
Before we dive straight in we’ll briefly explain some of the key terms you will find helpful and will help you make an informed decision about which one to invest in.
What is a stock?
A stock is a type of security that represents part-ownership of a company. When you invest money into a stock, you receive shares in that company which lets you know how much of that company you own. A company issues shares to raise capital.
What is a stock warrant?
A stock warrant gives you the right to buy a stock at a specific price on a specific date. It only acts as a contract that the company is legally obligated to honour if you choose to exercise it. However, you don’t have any ownership of the company.
Companies issue stock warrants to raise capital quickly, often in the early stages of growth. Investors benefit from paying a low price for a minimum investment with the potential to make a considerable profit.
The aim is for the exercise price to be cheaper than the future price or projected market value. Then you can sell the warrant for a profit. However, if the shares of the company never reach the exercise price, then the warrants aren’t worth anything. The warrant’s value rises when the share price rises. And warrants below their strike price are worthless unless you can sell them to someone else.
A number of different types of warrants exist. These categories include traditional warrants, naked warrants, and covered warrants.
What is a stock option?
A stock option is a contract between two parties. The buyer is given the right, but not the obligation, to buy (or sell) the underlying asset by a certain date (expiration date) at a specified price (strike price).
There are two types of options: calls and puts. American-style options can be exercised at any time prior to their expiration. European-style options can only be exercised on the expiration date.
What is a call option?
Calls give the buyer the right, but not the obligation, to purchase the underlying asset at the strike price specified in the option contract. Investors buy calls when they believe the price of the underlying asset will increase and sell calls if they believe it will decrease.
What is a put option?
Puts give the buyer the right, but not the obligation, to sell the underlying asset at the strike price specified in the contract. The seller of the put option is under obligation to buy the asset if the put buyer exercises their option. Investors buy puts when they believe the price of the underlying asset will decrease and sell puts if they believe it will increase.
Warrants and options give investors the opportunity to make a profit!
Both warrants and options are investment/financial contracts that will allow you to buy stock from a specific company at a specific price and time. They are also both designed to give investors the opportunity (but not a guarantee) of making a profit on that investment. Furthermore, both are widely traded on major financial exchanges like the Nasdaq Stock Market or New York Stock Exchange.
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Key differences between warrants and options
Here are the main differences of warrants vs options (excluding stock options for remuneration by management):
- Warrants are securities issued by companies and bought by investors. Options are contracts between two investors.
- Warrants involve the issue of new shares by the company, which dilutes share values. Options do not create any new shares.
- Warrants are usually bought and sold on the Stock Exchange. Options are usually traded on an options exchange (such as the Chicago Board Options Exchange).
- Warrants usually run for around three to five years and have a longer life. Options have a maximum life of nine months, with peak activity in the first three months.
Warrants vs options: Which should you choose?
Investing in both warrants and options have their pros and cons, but stock options tend to be the more common trading strategy.
You can use options in a wider variety of trading strategies than warrants. They are also easier to buy and sell. The most important advantage of options over warrants is you can only sell the former. You can only buy warrants and only the entities that issue them can sell them.
However, the price of warrants is usually lower, which means you have the potential to supercharge your profits. During a bull market, your profits might really take off and during a bear market warrants will provide you with some additional protection.
Stock warrants are favourable if you’re building an investment portfolio according to most investors. They also allow smaller investors to mix up their investments without diving into the more competitive stocks. Corporate transactions that offer warrants as an equity sweetener can be appealing to existing holders and investors.
Be mindful that the potential for larger gains also means a potential for greater loss. One way investing in warrants results in a loss is when the value of the certificate decreases to zero. Obviously, you lose any potential value if this happens before exercising the warrant.
Warrants do not provide the buyer with any voting, shareholding, or dividend rights within the company, unlike a stock option.
Factors to consider
When deciding on warrants and options this depends on various factors including your investment strategy, goals, risk tolerance and timescales for investing.
Warrants are a great long-term investment option as they have a maximum validity of 15 years. Options are often for short terms investors as they don’t have such long expiry periods.
Obviously investing in warrants and options comes with a certain degree of risk and volatility. But both can be extremely lucrative if utilised correctly.
COVID-19 has highlighted that markets are entirely outside of our control so do take this into account.
Diversifying your portfolio
If you want to diversify your investment portfolio, warrants and options are worth considering. Companies can use warrants to raise capital while investors can use them, as well as options, to make a profit. Both warrants and options can be structured for either selling or buying (but not both). Knowing the risks and rewards involved is important when deciding whether to invest in either one.
Warrants in UK stocks
Many placings in the UK will see companies issue warrants to sell the deal to investors.
I’m often shown deals where there will be a fixed price for the placing, and warrants are offered alongside by the issuer. These warrants can help raise more money for the company in the short-term if they are exercised and taken up.
For example, in a recent placing for Gfinity, I took part in a deal where 1 warrant was offered for every share applied for at a stock price of 1.25p.
In this instance, the warrant’s price was the same price as the stock. But often the strike price can be higher. If the warrants are exercised, this increases the number of shares in the company but provides the company with new money. Warrants will usually have a time value attached and once this expiry date has passed then the unexercised warrants automatically expire worthless.
Warrants can sometimes harm the underlying stock price as investors sell the equity and retain the risk-free upside warrant.
The warrants offer a form of leverage to the investor because warrants only require capital to be put down when exercised. Investors receive a warrant certificate for their number of warrants and must fill in a document in order to exercise the warrants in the underlying security. Usually, investors then sell shares that they received in the warrant exercise.
In the UK, warrants are subject to capital gains, however, you can exercise these and sell stock in a spread bet account and avoid this tax.