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Stock Warrants 101: What Are They and How Do They Work?

John Divine

While the stock market can be difficult for even savvy investors to navigate successfully, at the end of the day stocks are still a well-known investment option that anyone can access with relative ease. Stock warrants, on the other hand, are far more obscure and less accessible.

That said, certain unique features of these financial derivatives can make them singularly attractive investments, with the sort of potential returns few other vehicles can offer.

Of course, there are always trade-offs and qualifiers. Still, there's no point in limiting your options, and opportunistic investors should at least educate themselves on this arcane corner of the markets. What follows is a brief overview of stock warrants and how investors can use them.

What Are Stock Warrants?

Stock warrants, like stock options, give investors the right to buy (via a call warrant) or sell (via a put warrant) a specific stock at a certain price level (strike price) before a certain date (expiration date). Warrants are good for a fixed period of time, but they aren't worth anything when they expire.

[READ: How to Use Defensive Investments to Shield Your Portfolio.]

How Do They Work?

A simple hypothetical example most easily illustrates how these investments work. Consider the imaginary company Widget Inc. (WIDG). In July 2020, Widget stock is trading for $100 per share, and the company issues call warrants with the following features:

-- The strike price (sometimes called "exercise price"): $130 per share.

-- Expiration date: July 1, 2025.

-- Warrant price: $5.

Suppose in July 2020 you saw this warrant and figured that, in five years, WIDG stock would easily be able to go up 50% from current levels. So the stock would trade for $150 within five years.

If you were pretty certain in that assessment -- and had the risk tolerance to do so -- loading up on these warrants would make financial sense. The right to buy one share of Widget stock for $130 will be worth at least $20 per share if WIDG gets to $150, which is quadruple what you paid for the warrant.

The downside, however, is that if Widget stock trades for less than $130 by July 2025, the warrant would be worth nothing and you'd lose that investment.

Stock Warrants vs. Stock Options

Unlike options, "warrants generally do not give the owner the right to buy 100 shares of the stock," says Robert Johnson, professor of finance at Heider College of Business, Creighton University. "Warrants may give the owner the right to buy one or some other number of shares." As with any investment, be sure to know exactly what you're buying. Is it a right to buy or sell one share, 10 shares or 100 shares?

Also, unlike options, warrants are issued by the company itself. Stock options, on the other hand, can be freely created by individual market participants who may be trying to speculate, hedge their position or earn extra income. "A warrant is different from an option because the company doesn't receive the proceeds from an option," says Steve Sosnick, Interactive Brokers chief strategist.

For the typical individual investor, "warrants have virtually all the same characteristics and may serve most of the same objectives as call options or long-term equity anticipation securities (LEAPS)," Johnson says.

[See: 7 Cash-Strapped Companies That Should Survive.]

So why ever buy a stock warrant? The most important practical difference between warrants and options is that "they can have longer lives; LEAPS are constrained," Sosnick says.

Most options trading happens on contracts that expire in days, weeks or months; those with the longest durations, the LEAPS, only go out about two years.

Stock warrants, however, can sometimes confer the right to buy or sell for many years down the road: On occasion, those dates can be five or 10 years down the line, giving the buyer a lot of time for the wager to play out.

Long-term stock warrants that give the right to buy an underlying stock (i.e., call warrants) generally offer the most explosive potential for appreciation -- in the best-case scenario for a put warrant, the stock will go to zero, which caps the maximum potential profit per warrant. In theory, there is no maximum potential profit per call warrant, as there's no firm limit to how high a stock's price is allowed to go.

One other feature to know about stock warrants before you buy them is whether they're American or European. European warrants are less desirable: They can only be exercised on the expiration date. American warrants give investors the right to buy or sell the underlying stock at any time before the expiration date.

Pros and Cons of Stock Warrants

For the average investor, financial derivatives simply aren't a necessary or fruitful tool for building wealth. Individual stocks are easily accessible, not difficult to understand and simple to trade. Plus, the wide availability of low-cost broad market exchange-traded funds make betting on the entire market easier than ever.

[See: 7 Best Sector ETFs to Buy for Growth]

That said, there's nothing wrong with knowing what tools are out there. Generally speaking, here are some of the main pros and cons of stock warrants.

Pros

-- High upside potential.

-- Exercise date can be very far off.

-- The strike price may be adjusted down by dividends.

This last point is yet another tidbit that can characterize these instruments. The strike price of a call warrant can sometimes be adjusted lower over time if the company pays dividends, benefiting the buyer.

Cons

-- Risky, volatile.

-- Scant availability.

-- Additional complexity (callable, price adjustments and more).

This last point is arguably the most important: Stock warrants are complicated. They're not all created equal, and their terms depend on what the company issuing them sets out. Sometimes, "in the money" call warrants can be "called back" by the company, forcing investors to sell. And while dividends paid may lower the strike price in certain situations, warrants can also be written to have the strike price tick higher incrementally over time.

"I've seen all kinds, some of them are callable, some of them get triggered at a certain share price," says George Calhoun, a professor in the School of Business at the Stevens Institute of Technology in New Jersey.

Where to Buy Stock Warrants

"Typically, warrants are issued by more speculative companies," Sosnick says. "It's fairly rare to see warrants on what we call blue-chip companies." That's certainly true, and sometimes even knowing what warrants exist on the market can be an effort. However, curious investors can find lists of current warrants with a little Googling, and from there, many mainstream online brokers will allow investors to trade them.

Typically, warrants will be traded under the underlying stock symbol with either a "W" or "WS" tacked on the end. At the moment, two of the more prominent companies with stock warrants investors can buy are American International Group (ticker: AIG) and DraftKings ( DKNG).



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