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What are stock warrants?

A simple investment instrument that bets on the future price of a company’s stock.

A stock warrant is a financial instrument that acts as an agreement between the company that issues the warrant and the investor that buys it. The warrant gives the investor the right to buy or sell a certain number of shares from the company at a certain price before an expiration date. This is not an obligation to buy or sell the shares, though.
If the investor decides to buy the shares, they exercise the warrant. Until then, the investor doesn’t own any shares, can’t vote as a shareholder and can’t collect dividends from the company.
Fun fact: “American-style” warrants can be exercised anytime before the expiration date, while “European-style” warrants can only be exercised on the expiration date.

Stock warrant

A stock warrant allows the holder to buy shares of a company’s stock at a set price — a discount to the market price — before the expiration date. They are bought and sold through stock brokers, but not listed like stocks.

How stock warrants work

Suppose Company X wants to raise capital. It offers warrants to give investors the right to buy company shares at $10 per share within the next four years. Currently, the company’s shares trade at $7 per share.
If the investor believes the company will be worth more than $10 in the next four years, they buy the right to purchase 1,000 shares at $10 per share. To buy the warrant, the investor pays $0.50 per share, or $500 total for the 1,000 shares.
Four years later, Company X trades at $25 per share. The investor decides to exercise the warrant and buy the 1,000 shares at the agreed price of $10. The investor pays $10,000 to buy the shares for a total cost of $10,500 ($10,000 for the shares plus $500 to buy the warrants four years ago). The investor can now sell the shares at the market price of $25, or $25,000 total, and pocket $14,500 profit.
Alternative scenario: Four years later, Company X trades at $5 per share. The investor would not exercise the warrant and will only lose the initial $500 paid to buy the warrant. The investor could also sell the warrants to someone else before the expiration date.

Reasons companies issue stock warrants

Companies issue warrants to raise capital or make their bonds more attractive. Sometimes a bond may have a warrant attached to it, but it will pay less interest than a bond without a warrant. In this case, investors who want to earn more on interest and don’t want to buy the company shares can opt in to buy bonds without warrants.
By issuing warrants, the company profits in two main ways:

  1. Investors pay a fee to purchase warrants, which goes to the company as capital.
  2. When the investor exercises the warrant and buys shares, the company gets the money by selling the shares to the investor.

4 types of warrants

There are four types of warrants that slightly differ in one aspect: whether you have to buy bonds or preferred stock along with the warrants.

Warrant typeDefinition
TraditionalThis type of warrant is offered as a detached part of a bond or preferred stock. The investor can “detach” the warrant and sell it individually while keeping the bonds or preferred stock.
WeddedWedded warrants are attached to a bond. You can’t “detach” the warrant and sell it individually; you have to sell both.
CoveredCovered warrants are those bought by a financial institution from the issuing company. The financial institution can then sell the warrants to investors.
NakedThe most basic type of warrant without any attachments like bonds or preferred stock deals.

Call warrants vs. put warrants

You can buy two types of warrants: call warrants and put warrants.

  • Call warrants give you the right — but not the obligation — to buy the company stock at a particular price within a set time frame.
  • Put warrants give you the right — but not the obligation — to sell the company stock at a particular price within a set time frame.

Stock warrants vs. stock options

Stock warrants are similar to stock options in the sense that they both give you the right but not the obligation to buy or sell shares of stock. But there are differences.

Stock warrantsStock options
Issued by the company over the counterTraded between investors on an exchange
New shares are issued and can cause dilution if warrants are exercisedExisting shares are traded and there is no dilution
Used for companies to raise capitalDoesn’t affect the company
Expiry date up to 15 years in the futureTypically last for a few months

Taxes on stock warrants

Stock warrants are considered taxable income at the amount of the difference between the exercise price and the price of a share when you exercise the warrant, minus the cost basis. Here’s an example:

  1. You exercise warrants at $10 per share to buy 1,000 shares.
  2. You paid $500 for the warrants.
  3. Your total cost is $10,500 when you exercise your warrants — $500 to buy the warrants plus $10,000 to buy 1,000 shares at $10 per share.
  4. Suppose the market price on the day of exercise is $25. Your shares are worth $25,000.
  5. The difference between the cost to buy the warrants and the shares at the agreed price ($10,500) and the price of shares when you exercised your warrants ($25,000) is $14,500.
  6. This $14,500 is taxable as ordinary income in the year of exercise. This isn’t considered a capital gain because you didn’t own shares until you exercised your warrants.

Capital gains and losses
You have two options:

  • Sell the shares you bought by exercising the warrants right away.
  • Hold the stock.

If you hold the stock, the exercise price becomes your cost basis. Gains or losses from that price onward are considered a capital gain or loss. Shares you hold for more than a year after exercise is considered a long-term gain or loss.

Stock warrant pros and cons

Buying stock warrants can be useful, but there are drawbacks to consider.

Pros

  • Can earn a profit if the company has strong growth potential
  • Relatively low entry bar.
  • You don’t have to purchase shares if the exercise price is higher than the current market price

Cons

  • You don’t own any shares, only the right to buy them
  • You may find it hard to sell your put warrants if the company goes bankrupt
  • You can only purchase warrants over the counter, not on an exchange

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Bottom line

Stock warrants can be a decent investment option if you believe in the company that offers them. This can give you the option to purchase shares at a lower price than what it could trade in the future. But be sure to do your research to determine whether they’re right for you.

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