What are stock warrants?

A stock warrant is a contract between a company and an investor giving the investor the right to buy or sell the company’s stock within a certain time frame for a specific price. It’s a derivative contract, which gets its value from the underlying asset.

Here’s how stock warrants work, their different types and how to invest in them.

How do they work?

A stock warrant is a financial instrument that gives the holder the right, but not the obligation, to buy or sell a specific number of shares of a company’s stock at a predetermined price within a certain time frame. The predetermined price is called the “strike price,” similar to a call option on a company’s stock. American stock warrants can be used anytime within the allotted term, including on the expiration date, while European warrants can only be exercised on the expiration date.

Why do companies issue warrants?

Companies can issue warrants as a way to raise capital. By selling stock warrants, companies bring in money immediately, and again later when the warrants are exercised. For investors, warrants are an incentive to buy the company’s stock because they offer the potential for a higher return. Companies may also choose to offer stock warrants as a benefit for their employees and to incentivize new hires.

Types of warrants

There are two main types of these instruments: call warrants and put warrants. Call warrants allow you to buy a stock, while put warrants allow you to sell.

Here’s how they work:

Call warrants

Call warrants are the most common type of warrant. The holder has the right to purchase a stock at a predetermined strike price within a specific time frame that ends on the warrant’s expiration date.

Let’s say you hold a call warrant for Company A with a strike price of $75 and the expiration date is six months away. If the price of the underlying stock is $75 or less during those six months, you should let the warrant expire. If, however, the price increases beyond the strike price, say to $105, you could exercise the warrant and buy the stock for $75, netting yourself $30 per share.

Put warrants

Put warrants grant you the right to sell a certain number of shares back to the issuing company at a strike price. To make the most of a put warrant, you’d want the market price of the stock to drop below your strike price so that you can sell at a profit. If you sell when the stock is higher than the strike price, you’d lose money. Using the above example, if the stock drops to $40, you could sell at your $75 strike price and gain $35 in profit.

How do you buy stock warrants?

You can buy and sell stock warrants through a brokerage account, just like you would with other securities. However, warrants are not as widely traded as stocks, so you may need to do some research to find a broker that offers them.

Another way to buy stock warrants is through a special purpose acquisition company (SPAC). SPAC IPOs typically offer investors “units” to purchase, which consist of shares and warrants, or fractions of warrants. You’ll find information about how to redeem warrants in the investment prospectus, a document that covers the particulars of the investment.  Keep in mind Investing in SPACs can be risky and is generally better suited for experienced investors who can weather financial losses.

Stock warrants vs. stock options

While similar, stock warrants and stock options have a few key differences:

  • Issuer. Warrants are issued by a company while options are created by investors and traded on the secondary market.
  • Duration. Warrants can have expirations five, ten or more years in the future, while options contracts are typically short-term, with terms under a year.
  • Purpose. Companies use stock warrants to raise money while stock options are used by investors as a speculative instrument.

What happens to the stock price when warrants are exercised?

When a warrant is exercised, the holder buys or sells at the strike price.

When a warrant holder is a buyer, it forces the underlying company to issue new shares, which has a dilutive effect for existing shareholders because the number of outstanding shares increases. This could send the price of the company stock lower. However, exercising a stock warrant is only one of many factors that impact a stock price day to day. Market conditions, the number of warrants being exercised and many other factors all play a role in determining a stock’s price.

Bottom line

Stock warrants can be a useful tool for companies to raise capital and for investors to make money. However, like most investments, they do come with risks. Before investing in stock warrants, be sure you understand how they work and whether your finances can tolerate the risk.

Editorial Disclaimer: All investors are advised to conduct their own independent research into investment strategies before making an investment decision. In addition, investors are advised that past investment product performance is no guarantee of future price appreciation.