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Wednesday, February 28, 2024

Stock warrants: What are they and how do they work?

Stock warrants: What are they and how do they work?

A stock warrant is a contract that gives someone the right to buy or sell a security at a certain price before a specific date. It’s a type of derivative, similar to an option, which is a financial contract that derives its value from an underlying asset. Stock warrants are an advanced investing strategy, meaning they may not be appropriate for most investors.

How do stock warrants work?

Warrants are derivatives that companies issue that give investors the right — but not the obligation — to buy company stock at a particular price (known as the strike price) on or before the expiration date. American warrants allow the investor to exercise anytime on or before the expiration date, while European warrants allow an investor to exercise only on the expiration date.

Note: Stock warrants aren’t particularly common in the United States, but are used more frequently in other countries.

One of the most important features of warrants is that investors aren’t obligated to exercise them. Instead, they might choose to do so only if the strike price is attractive compared to the current market price. For example, if the warrant allows an investor to purchase a stock for $20 per share and it’s currently trading at a market price of $25, the investor could purchase it for a $5 per share discount.

When someone exercises a warrant to buy shares from a company, the company issues new shares of stock to fulfill it. Because of this, warrants can be dilutive, meaning they reduce the percentage of ownership of each individual share. If a warrant is profitable before it expires, it’s considered to be “in the money.”

On the other hand, if a warrant is out of money, meaning it wouldn’t be profitable for the investor to exercise, then the investor is likely to simply let it expire. In that case, they are only out the fee they paid to purchase the contract.

Warrants are sometimes issued attached to bonds. For example, a company might issue bonds with call warrants attached to them. Investors get the benefit of owning the bond, including the interest payments. But they also get the added benefit of having the right to purchase company stock down the road, possibly for a discount.

Types of stock warrants

All stock warrants fall into one of two categories: call warrants and put warrants.

Call warrants

A call warrant gives an investor the right to buy a company’s stock at a certain price on or before a specific expiration date. Generally speaking, an investor would be likely to exercise a call warrant if the strike price is lower than the stock’s current market price.

Put warrants

A put warrant gives an investor the right to sell a company’s stock at a certain price on or before a specific expiration date. In the case of put warrants, the investor would be selling the shares back to the company that issued them. An investor would be likely to exercise a put warrant if the strike price is higher than the stock’s current market price.

Other types of warrants

All warrants are either call warrants or put warrants. But there are also other types of warrants within those two categories.

  • Traditional warrant: This type of warrant is typically attached to another type of security, such as a bond or preferred stock, as a way of incentivizing an investor to buy.
  • Covered warrant: This type of warrant is issued by a party other than the company. For example, they can be issued by financial institutions.
  • Naked warrant: This type of warrant simply allows the investors to buy or sell the stock. It’s not attached to another security.
  • Wedded warrant: This type of warrant is attached to another security and isn’t detachable. The investor must give up the other security to exercise the warrant.

Stock warrants vs. stock options

Stock warrants and stock options are both derivatives contracts that give investors the right — but not the obligation — to buy or sell a company’s stocks at a strike price on or before the expiration date. And while the two are very similar, there are also some key differences.

The first difference between warrants and options is who issues them and where they trade. Warrants are usually issued directly by companies. And if you exercise the warrant, you buy the stocks from or sell the stocks to the issuing company. Options, on the other hand, trade on secondary markets. Rather than being contracts between a company and an investor, they are contracts between two investors or between a financial institution and an investor.

Because options are traded on the secondary market between two third-parties, the underlying security is one that’s already been issued. But in the case of a call warrant, the company must issue new shares if the investor decides to exercise the warrant. As a result, warrants are dilutive in nature, while options aren’t.

Another difference between warrants and options is who benefits from them. Companies issue warrants for two reasons — to raise capital and to entice investors to purchase other securities, such as bonds. But options are issued by third parties, meaning the company doesn’t get any of the money. Instead, it’s only the investors in the contract that benefit.

A final difference worth noting is the lifespan of these derivatives. Warrants often have long lifespans, allowing investors to exercise them as many as 5, 10, or even 15 years in the future. But with stock options, investors don’t tend to buy out beyond a year because of the time-value of money.

Stock warrants

Stock options

Contract between a company and an investor

Contract between two investors

Result in the creation of new shares

Don’t result in the creation of new shares

Help companies raise capital

Can help investors make money

Lifespans of 5-10 years

Lifespans of days, weeks, or months

Taxes on stock warrants

Warrants usually result in taxable income at the time you exercise them. The taxable portion of the warrant is the difference between the exercise price and the stock’s current market price. For example, if a stock is trading at $25 per share and you have a warrant that allows you to buy the shares at $20 per share, the $5 difference would be taxable.

Because you didn’t own the stock before you exercised the warrant, the profit is taxed as income rather than a capital gain. As a result, you’ll pay your ordinary income tax rate.

There will also be a tax consequence if and when you decide to sell the stock. If you hold the stock for less than one year before you sell, you could be subject to short-term capital gains taxes, which mean you’re taxed at your ordinary income tax rate. But if you hold the stock for more than one year before you sell, you’ll be eligible for the more favorable long-term capital gains tax rates.

Why do companies issue stock warrants?

One of the primary reasons companies issue warrants is to entice investors to purchase other securities. As we mentioned, stock warrants often come attached to either bonds or preferred stock. Depending on whether it’s a traditional warrant or a wedded warrant, it either gives the option to exercise the warrant and buy additional shares on top of the securities they already hold or it gives the investor the right to trade the other security in for shares.

For example, suppose a company issued bonds with a face value of $1,000. The bonds had wedded warrants attached to them, meaning investors could exercise the warrant to buy shares of stock, but would have to surrender the bond to do so. In the case of a traditional warrant, however, the investors could keep the bond and still exercise the warrant.

Another reason companies issue bonds is to create future cash flow. Warrants often have lifespans of a decade. So when a company issues them, they aren’t necessarily anticipating that they’ll raise capital right away. However, the warrants could result in incoming cash flow for the company at any time throughout that decade, providing a nice revenue boost in the future.

Finally, a company might issue stock warrants as a way to attract key employees. Warrants for employees aren’t as popular in the United States — most companies offer stock options instead. But companies in Europe and other parts of the world may use warrants instead of options as a part of an employee’s compensation package.

Are stock warrants a good investment?

Stock warrants aren’t inherently a good or bad investment. In some cases, warrants can be a great investment. Investors can purchase the warrant either for a small fee or attached to another type of security. Then, they have the potential to buy a company’s stock for a serious discount in the future.

However, warrants also have some downsides that could make them a poor investment for some people. First, warrants aren’t always profitable. If you aren’t able to exercise the warrant for a profit, you’ll probably think it wasn’t a good investment.

Warrants can be a high-risk investment. When you buy a call warrant or put warrant, you’re essentially betting that a stock’s price will move one direction or the other. No one can predict the future of the stock market with perfect accuracy — not even financial professionals. You always run the risk of the stock moving in the opposite direction you thought it would, meaning you lose the fee you paid for the warrants and aren’t able to issue them.

The good news is the company takes on the bulk of the risk when issuing warrants. The most an investor can lose is the fee they paid for the warrant contracts.

Another thing to consider when buying warrants — and a reason investors may not find them as appealing as just buying stock — is they don’t come with the perks of stock ownership. Until you exercise the warrant, you don’t have voting rights in the company and aren’t eligible to earn dividends. As we mentioned, warrants can have lifespans of a decade (or even more). If you hold the warrant for most or all of that time, you could potentially have made a lot more money in dividends during those years.

When are stock warrants profitable?

Warrants are profitable — or “in the money” — when they allow an investor to buy a stock for less than its market price or sell a stock for more than its market price.

A call warrant is profitable when its strike price is lower than the market price of the underlying stock. For example, suppose you purchased a stock warrant that allowed you to purchase shares of a company’s stock for $10 per share.

If the stock’s current market price is $9, it doesn’t make sense to exercise the warrant, since you could purchase the stocks in the secondary market for a lower price. But once the stock’s market price reaches $11 or more, you can buy it for a discount with your warrant and it would be considered profitable.

In the case of a put warrant, the investor can make a profit when the stock’s market price is lower than the strike price on the warrant. Suppose an investor held shares of a company’s stock with a market price of $25. But you have a put warrant that allows you to sell the shares back to the company for $30.

Because the warrant allows you to sell the stocks for more than you could on the secondary market, the warrant is in the money and makes sense to exercise. But if the stock’s current market price was $35, it wouldn’t make sense to exercise the warrant, since you could sell the shares for more elsewhere.

Our take

Stock warrants can be very profitable for investors, allowing them to buy stock at a discount or sell stock for far more than the market price. For the right investor, they can represent an excellent earning opportunity.

However, stock warrants can be confusing at best and come with their fair share of risks. You’re essentially betting on the future of the stock market without receiving any of the benefits of being a shareholder right now. As a result, they aren’t an appropriate investment for most people.

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