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

The security represented in the warrant—usually share equity—is delivered by the issuing company instead of a counter-party holding the shares. A warrant can also increase a shareholder's confidence, provided the underlying value of the security increases over time. Let's examine the types of warrants, their characteristics, and the advantages and disadvantages they offer.

Types of Warrants

There are two different 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, which is the last day the rights of a warrant can be executed.

Warrants are also classified by their exercise style. For example, an American warrant can be exercised anytime before or on the stated expiration date, while 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 needed to buy or sell one investment unit. For example, a call warrant states the conversion ratio to buy stock XYZ is 3:1, meaning the holder needs three warrants to purchase one share.

Typically, the share price will be low if the conversion ratio is high, and vice versa. An index warrant carries an index multiplier instead of a conversion ratio, with that number used to determine the amount payable to the holder upon the exercise date.

Investing in Warrants

Warrants are transparent and transferable certificates which tend to be more attractive in medium- to long-term investment schemes. These often high-risk, high-return investment tools remain largely unexploited in long-term strategies while offering an attractive alternative to speculators and hedgers. Even so, warrants offer a viable option for private investors because the cost of ownership is usually low and the initial investment needed to command a large amount of equity is relatively small.

Advantages of Warrants

Let's look at an example that illustrates one potential benefit of warrants. Say that XYZ shares are currently quoted at $1.50 per share. At this price, an investor would need $1,500 to purchase 1,000 shares. However, if the investor opted to buy an XYX call warrant (representing one share) that was priced at $0.50, 3,000 shares could be controlled with the same amount of capital.

Because warrant prices are typically low, the leverage and gearing they offer are typically high, generating potentially larger capital gains and losses. While it's common for share and warrant prices to move in tandem in absolute terms, the percentage gain or loss will vary significantly because of the initial price difference. Saying it another way, warrants tend to exaggerate the percentage change movement compared to the share price.

Another Example of Warrants

Let's look at another example to illustrate these points. Say that XYZ shares gain $0.30 from $1.50 and close at $1.80, generating a 20% gain. At the same time, the warrant gains $0.30, rising 60% from 0.50 to $0.80. In this example, 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 the warrant offers. The higher the number, the larger the potential for capital gains or losses.

As a real-life example, 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

Like any other type of investment, warrants also have drawbacks and risks. As mentioned above, the leverage and gearing that warrants offer can be high, but these can also work to the investor's disadvantage.

Let's say we reverse the outcome of the XYZ example and realize a drop in share price by $0.30. In this instance, the percentage loss for the share price would be 20%, while 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 because, if it happens before exercised, the warrant would lose any redemption value.

Finally, a warrant holder has no voting, shareholder, or dividend rights and gets no say in the functioning of the company, even though they are affected by their decisions and policies.

The Bottom Line

Warrants can offer a useful addition to a traditional portfolio, but investors need to be attentive to market movements due to their risky nature. Even so, 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.