What is a warrant?
Introduction
Certain corporations in the U.S. issue publicly traded warrants. Our database currently contains 2 warrants that are traded on U.S. stock exchanges. See our list of warrants.
A warrant gives you the right to buy a company's common stock at a specific price (referred to as the "exercise price") during a specific date range (the "exercise period"). Most warrants give you the right to buy one share of common stock, but that can vary by the warrant. For example, some warrants only give you the right to buy 1/2 of a share of common stock, so obviously you have to buy two warrants to fully exercise the right to buy one common share.
A warrant is very similar to a stock option, but the difference is that warrants are issued directly by the company, whereas stock options are securities that are bought and sold between individual investors. Warrants are also different than stock options in that warrants can have longer exercise periods than stock options, which often expire in one year or less. Warrants often have a five year exercise period.
Warrants are bought and sold just like any other security. So most warrants are bought and sold by short-term traders who never actually exercise the warrant. But if the warrant is "in the money", the warrant can be exercised through your broker. The broker can arrange for the company to issue additional shares in exchange for your warrant. A warrant is "in the money" when the exercise price of the warrant is less than the common stock's current market price. Obviously, there's no reason to exercise a warrant that is not in the money, as you would lose money on the transaction.
Warrants are primarily issued by SPACs
Most warrants trading on the market today are related to special purpose acquisition companies ("SPACs"), or shell companies. A SPAC is a newly formed public company that is formed to enter into a merger with a privately held operating company. Merging with a SPAC has become a popular way for a privately held company to "go public", rather than the traditional IPO process. If you are new to SPACs, you can read what is a SPAC?
Almost all SPACs initially go public by issuing a unit which typically includes a share of a common stock in the SPAC and 1/2 or 1 warrant to purchase shares in the SPAC. Within a few months, the SPAC typically arranges for the common stock and the warrants to start trading on their own, with their own symbols.
Warrants are popular with SPACs because issuing a warrrant is an easy way to give an investor some huge upside in a potential SPAC merger. If the SPAC merger is successful, any investor holding warrants in the SPAC will earn a tremendous return.
Warrants are a form of leverage
Similar to certain types of options, warrants are a form of leverage. If an investor can buy a warrant for $.50 per warrant that includes the right to buy the company's stock at an exercise price of $11.50 per share, the investor is able to "capture" the potential gains or losses on the future market price of the common stock, without expending very much capital. The built in leverage is massive. There is no precise way to measure the amount of leverage in a warrant, but think of it as using leverage that is in the range of 8x to 10x.
Here's an example. Let's say that today there is a warrant to purchase shares of XYZ corporation that is currently trading at $1.00 per share. The exercise price of the warrant is $11.50 per share of XYZ corporation common stock. XYZ's common stock is currently trading at $10.00. Let's look at a scenario where the market price of XYZ's common stock is going to go up over the next six months to $20 per share (i.e. it will double in price). If you buy the common stock, your rate of return after six months is 100%. But if you buy the warrant, the warrant's market price will probably go up to around $11 per warrant. So your rate of return if you bought the warrant would be 1000% (($11-$1)/$1). So the leverage factor in this scenario is 10x.
Because of the leverage, the market prices of warrants can be extremely volatile. Short-term trading in warrants can be extremely profitable, but you can also lose a lot of money doing it. A warrant can easily lose 25% of its value in just a few days.
The use of leverage in investing is controversial at any level. Leveraged ETFs have become very popular, and most leveraged ETFs have a leverage factor of 2x or 3x. And the U.S. Securities and Exchange Commission is constantly worried that investors don't fully understand the risk they are taking when they buy a 2x or 3x leveraged ETF. So keep that in perspective if you think about buying a warrant that is a 10x leveraged investment.
You can lose all of your investment
Similar to certain types of options, you can easily lose all of your investment buying a warrant if the warrant expires and the warrant is "out of the money" -- i.e. the exercise price is below the value of the stock. Think about that. There aren't that many investments you can make that can easily result in you losing all of your investment. We probably shouldn't call it an "investment" as buying a warrant is more like gambling.
Warrants are so risky because it is very difficult to time the stock market. Let's look at an example. Let's say you are considering buying a warrant that has two years left on the exercise period. The warrant allows you to buy stock in XYZ company for $10 per share when XYZ's stock is currently trading at $8 per share. Even if you believe that XYZ's stock is currently undervalued, and should "easily" be trading at $12 to $15 per share, it is extremely difficult to predict/know that XYZ's stock will increase in the next two years, before the warrant expires. Anything can happen. If the stock market crashes, it may take a few years before XYZ's stock fully recovers. So even if you are correct that the stock is "worth" $12 to $15 per share, you will still lose all of your investment if it doesn't increase to more than $10 per share before the warrant expires.
Studies of option trading have shown that most option traders are correct in terms of the direction of the trade. They generally guess correctly that XYZ's stock will eventually go up in value. But the reason they lose money on the option trade is the timing. In our example above, XYZ's stock does eventually go up to $15 per share, but it takes three years for that to happen. And the warrant expired worthless in two years. It is a very difficult thing to time.