Chapter 1: What is a Security? - E. Warrants

A warrant is a security that gives the holder the opportunity to purchase common stock. Like a right, the warrant has a subscription price; however, the subscription price is always above the current market value of the common stock when the warrant is originally issued. A warrant has a much longer life than a right — the holder of a warrant may have up to 10 years to purchase the stock at the subscription price. The long life is what makes the warrant valuable, even though the subscription price is higher than the market price of the common stock when the warrant is issued.

How Do People Get Warrants?

Units

Many times companies will issue warrants to people who purchased their common stock during its initial public offering (IPO). A common share, which comes with a warrant attached to purchase an additional common share, is known as a unit.

Attached to Bonds

Many times companies will attach warrants to their bond offerings as a “sweetener” to help market the bond offering. The warrant to purchase the common stock makes the bond more attractive to the investor and may allow the company to issue the bonds with a lower coupon rate.

Secondary Market

Warrants will often trade in the secondary market just like the common stock. An investor who wishes to participate in the potential price appreciation of the common stock may elect to purchase the corporation’s warrant instead of its common shares.

Possible Outcomes of a Warrant

A warrant, like a right, may be exercised or sold by the investor. A warrant also may expire if the stock price is below the warrant’s subscription price at its expiration.

Rights vs. Warrants

Rights Warrants
Term Up to 45 days Up to 10 years
Subscription price Below the market Above the market
Trading May trade with or without common stock May trade with or without common stock or bonds
Who Issued to existing Shareholders to ensure preemptive rights Offered as a sweetener to make securities more attractive

Options

An option is a contract between two parties, the buyer and the seller, that determines the time and price at which a security may be bought or sold. The buyer of the option pays money, known as the option’s premium, to the seller. For this premium the buyer obtains a right to buy or sell the security, depending on what type of option is involved in the transaction. The seller, because they received the premium from the buyer, now has an obligation to perform under that contract. Depending on the type of option involved, the seller may have an obligation to buy or sell the security.

Calls

A call option gives the buyer the right to buy or to “call” the security from the option seller at a specific price for a certain period of time. The sale of a call option obligates the seller to deliver or sell that security to the buyer at that specific price for a certain period of time.

Puts

A put option gives the buyer the right to sell or to “put” the security to the seller at a specific price for a certain period of time. The sale of a put option obligates the seller to buy the security from the buyer at that specific price for a certain period of time.

Bullish vs. Bearish

Bullish

Investors who believe that a security’s price will increase over time are said to be bullish. Investors who buy calls are bullish on the underlying security. That is, they believe that the security’s price will rise, and they have paid for the right to purchase the security at a specific price, known as the exercise price. An investor who has sold puts is also considered bullish on the security. The seller of a put has an obligation to buy the security, and therefore believes that the security’s price will rise.

Bearish

Investors who believe that a security’s price will decline are said to be bearish. The seller of a call has an obligation to sell the security to the purchaser at a specified price and believes that the security’s price will fall and is therefore bearish. The buyer of a put wants the price to drop so that they may sell the security at a higher price to the seller of the put contract. They are also considered bearish on the security.

Calls Puts
Buyers

Bullish

Have right to buy stock,

want stock price to rise

Bearish

Have right to sell stock,

want stock price to fall

Sellers

Bearish

Have obligation to sell

stock;

want stock price to fall

Bullish

Have obligation to buy stock;

want stock price to rise

F. Characteristics of All Options
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