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Warrant

Gives the holder the right to purchase a company's stock at a specific price and at a specific date

What is a Warrant?

A warrant gives the holder the right to purchase a company’s stock at a specific price and a specific date. In other words, a warrant is a long-term option to buy a given stock at a fixed price. Such a type of warrant is called a call warrant, which gives the right to buy the security. A put warrant gives an investor the right to sell the security.

 

Warrant

 

A stock warrant is issued directly by the company involved. It means that when an investor exercises a stock warrant, the shares that fulfill the obligation are not received from another investor but directly from the company.

 

Stock Warrant vs. Stock Option

A stock warrant should not be confused with a stock option, as a stock warrant is directly issued by the company to the investor, while a stock option is a contract between two people. Similarly, a call option gives the investor the right to buy a stock at a specified time and price, while a put option gives the right to sell at a specified time and price.

 

Call Warrant Example

Company ABC is trading at $1.00 per share and decides to raise $1 million in capital. The company would then finance at a price below the market rate of $1.00 per share to say $0.90 per share. As part of the financing, those who participate will receive a warrant as well; let’s price it at $1.20.

If ABC’s stock trades above $1.20 a year later, say at $1.30, the holder of the warrant reserves the right to purchase shares at $1.20. While they would need to lay out $1.20 per share to buy, they are automatically making $0.10 profit per share, when they sell.

Stock warrants are designed to help raise capital, encourage investors to invest, and create long-term interest in the stock of companies. They are also appealing to those investors who believe that a company offers an attractive long-term potential.

The idea behind such a scenario is that if your research and due diligence show that a company will perform well in the future, and if it is offering stock warrants, you are buying the shares at a discount and receiving the option to buy the stock at a fixed price in the future. The main caveat of a stock warrant is that if the stock value falls below the warrant’s price at the time of the expiry, the financial instrument ends up worthless.

If we were to run a reverse scenario and think that a stock is overvalued and its value will decrease in the future, you would buy a put warrant and hope that the stock’s price will decrease within a certain time frame.

 

Stock Call Option Example

A call option provides the investor with the right to buy 100 shares of stock at a specific price or the strike price, up until a specified date or the expiration date. A put option gives the investor the right to sell 100 shares of stock at a specified price and date.

If your research shows that ABC’s stock offers a strong future outlook and is worth $100 per share, you could buy an option, which is 100 shares for $10,000. If ABC’s value goes up in price to $110 per share, you will make $1,000 in profit ($11,000 – $10,000).

In the case where you are very confident in ABC’s performance in the future, you could buy a $110 call option for, say $240. It would give you the right to buy 100 shares of ABC for $110 per share at any time within a specified time frame. If ABC stock price goes up to $150 per share, you make $3,760 profit ($15,000 – $11,000 – $240); however, you’ve only put forward $240 in investment rather than $10,000.

If ABC’s stock underperforms and its value drops to $90 per share, the individual who bought the shares would realize a loss of $2,000 ($11,000 – $9,000). However, the individual who bought the option can’t lose more than what they paid for, and, in this case, it’s $240.

 

Key Takeaway

Warrants are great for seasoned investors with strong reasons to believe that the company will either perform strongly in the future or miss its projections. In the first case, an investor would buy a call warrant, and in the second one, the investor would buy a put warrant.

 

More Resources

CFI is the official provider of the global Capital Markets & Securities Analyst (CMSA)® certification program, designed to help anyone become a world-class financial analyst. To keep advancing your career, the additional CFI resources below will be useful:

  • Capital Raising Process
  • Options: Calls and Puts
  • Spot Price
  • Types of Due Diligence

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