Stock options and Stock warrants are two extremely popular derivative instruments that are traded in stock and derivative exchanges all over the world.
Because stock options and warrants share the same leverage characteristics, they have been commonly assumed to be the same instrument called different names. Nothing is further from the truth. Even though stock options and stock warrants behave in almost the same fashion and can be traded in the same fashion, they are actually fundamentally different instruments.
Even though a tiger roars like a lion roars, they are actually different animals with their own unique characteristics. Similarly, stock options and warrants have their own characteristics as well.
In finance, a warrant is a security that entitles the holder to buy the underlying stock of the issuing company at a fixed exercise price until the expiry date.
Warrants and options are similar in that the two contractual financial instruments allow the holder special rights to buy securities. Both are discretionary and have expiration dates. The word warrant simply means to "endow with the right", which is only slightly different from the meaning of option. A warrant is like an option. It gives the holder the right but not the obligation to buy an underlying security at a certain price, quantity and future time. It is unlike an option in that a warrant is issued by a company, whereas an option is an instrument of the stock exchange. The security represented in the warrant (usually share equity) is delivered by the issuing company instead of by an investor holding the shares.
Companies will often include warrants as part of a new-issue offering to entice investors into buying the new security. A warrant can also increase a shareholder's confidence in a stock, provided the underlying value of the security actually does increase over time.
Differences on the basis of Contracting Parties
Stock options are contracts between a person or institution owning a stock or willing to buy a stock and another person who either wants to buy or sell those stocks at a specific price. In this aspect, stock options are just like the option you sign when you buy a house from a seller of that house. It's a contract between a party who owned the stock through purchase from the open market and another party who wish to buy that stock from the writer of the options contract. It is essentially a contract between two investors. In this aspect, a Market Maker is an investor as well because they too accumulate those stocks and options from the open market.
Advantages
Let us look at an example that illustrates one of the potential benefits of warrants. Say that ABC shares are currently priced on the market for Rs. 15 per share. In order to purchase 1,000 shares, an investor would need Rs. 1,5000. However, if the investor opted to buy a warrant (representing one share) that was going for Rs. 5 per warrant, he or she would be in possession of 3,000 shares using the same Rs. 1,5000.
Because the prices of warrants are low, the leverage and gearing they offer is high. This means that there is a potential for larger capital gains and losses. While it is common for both a share price and a warrant price to move in parallel (in absolute terms) the percentage gain (or loss), will be significantly varied because of the initial difference in price. Warrants generally exaggerate share price movements in terms of percentage change.
Let us look at another example to illustrate these points. Say that share ABC gains Rs. 5 per share from 15, to close at Rs 20. The percentage gain would be 33.33%. However, with a gain in the warrant, from Rs. 5 to 10, the percentage gain would be 100%.
In this example, the gearing factor is calculated by dividing the original share price by the original warrant price: 15 / 5 = 3. The "3" is the gearing factor - essentially the amount of financial leverage the warrant offers. The higher the number, the larger the potential for capital gains (or losses).
Warrants can offer significant gains to an investor during a bull market. They can also offer some protection to an investor during a bear market. This is because as the price of an underlying share begins to drop, the warrant may not realize as much loss because the price, in relation to the actual share, is already low.
Let us look at an example that illustrates one of the potential benefits of warrants. Say that ABC shares are currently priced on the market for Rs. 15 per share. In order to purchase 1,000 shares, an investor would need Rs. 1,5000. However, if the investor opted to buy a warrant (representing one share) that was going for Rs. 5 per warrant, he or she would be in possession of 3,000 shares using the same Rs. 1,5000.
Because the prices of warrants are low, the leverage and gearing they offer is high. This means that there is a potential for larger capital gains and losses. While it is common for both a share price and a warrant price to move in parallel (in absolute terms) the percentage gain (or loss), will be significantly varied because of the initial difference in price. Warrants generally exaggerate share price movements in terms of percentage change.
Let us look at another example to illustrate these points. Say that share ABC gains Rs. 5 per share from 15, to close at Rs 20. The percentage gain would be 33.33%. However, with a gain in the warrant, from Rs. 5 to 10, the percentage gain would be 100%.
In this example, the gearing factor is calculated by dividing the original share price by the original warrant price: 15 / 5 = 3. The "3" is the gearing factor - essentially the amount of financial leverage the warrant offers. The higher the number, the larger the potential for capital gains (or losses).
Warrants can offer significant gains to an investor during a bull market. They can also offer some protection to an investor during a bear market. This is because as the price of an underlying share begins to drop, the warrant may not realize as much loss because the price, in relation to the actual share, is already low.
Differences on the basis of Customizability of Terms of Issue
Standardized stock options all around the world are issued with a fixed structure and framework with a common method of calculation, standardized policy of strike difference, standardized contract size and standardized terms of exercise / delivery. All these rules are set by the individual exchanges so that all participants may "play this game" on equal terms. This standardization is necessary as stock options are contracts between individual investors who may not be professional financial institutions.
Warrants, however, are highly customizable as the issuer crafts the terms of each new issue according to their needs at that point in time. The most significant of these customizable terms is what is known as the "conversion ratio" or "cover ratio". Conversion ratio is simply the number of stocks that are represented with each warrant contract. This conversion ratio varies with each warrant contract unlike the fixed contract size in stock options. In fact, each warrant contract may even convert to just a fraction of the underlying share rather than the 100 or 1000 shares in stock options. The life span of warrants are also commonly much longer than options as the issuers are free to decide on an expiration date that could go as far as 15 years in some countries. A warrant's lifetime is measured in years (as long as 15 years), while options are typically measured in months. Even LEAPS (long-term equity anticipation securities), the longest stock options available, tend to expire in two or three years. Upon expiration, the warrants are worthless unless the price of the common stock is greater than the exercise price.
Differences on the basis of Shorting
Because stock options are contracts between individual investors, anyone could produce a new option and throw it for sale into the market by "shorting" or "writing" using a Sell To Open order. Warrants, on the other hand, are issued by the issuing bank or financial institution only, hence they cannot be shorted.
Differences on the basis of Exercise & Delivery
Both Warrants and Stock options are either American, allowing the investor to exercise at any time during the life of the options, or European style, allowing the investor to exercise only during expiration. Warrants issued by the company itself are dilutive. When the warrant issued by the company is exercised, the company issues new shares of stock, so the number of outstanding shares increases. When a call option is exercised, the owner of the call option receives an existing share from an assigned call writer (except in the case of employee stock options, where new shares are created and issued by the company upon exercise). Unlike common stock shares outstanding, warrants do not have voting rights.Remember, the issuers of warrants are the issuing banks directly representing the companies issuing the shares. These companies win as long as their shares get sold and capital raised. This is unlike stock options where the investor selling the options could lose significant amount of money when call options they wrote gets in the money and then subsequently exercised.
Standardized stock options all around the world are issued with a fixed structure and framework with a common method of calculation, standardized policy of strike difference, standardized contract size and standardized terms of exercise / delivery. All these rules are set by the individual exchanges so that all participants may "play this game" on equal terms. This standardization is necessary as stock options are contracts between individual investors who may not be professional financial institutions.
Warrants, however, are highly customizable as the issuer crafts the terms of each new issue according to their needs at that point in time. The most significant of these customizable terms is what is known as the "conversion ratio" or "cover ratio". Conversion ratio is simply the number of stocks that are represented with each warrant contract. This conversion ratio varies with each warrant contract unlike the fixed contract size in stock options. In fact, each warrant contract may even convert to just a fraction of the underlying share rather than the 100 or 1000 shares in stock options. The life span of warrants are also commonly much longer than options as the issuers are free to decide on an expiration date that could go as far as 15 years in some countries. A warrant's lifetime is measured in years (as long as 15 years), while options are typically measured in months. Even LEAPS (long-term equity anticipation securities), the longest stock options available, tend to expire in two or three years. Upon expiration, the warrants are worthless unless the price of the common stock is greater than the exercise price.
Differences on the basis of Shorting
Because stock options are contracts between individual investors, anyone could produce a new option and throw it for sale into the market by "shorting" or "writing" using a Sell To Open order. Warrants, on the other hand, are issued by the issuing bank or financial institution only, hence they cannot be shorted.
Differences on the basis of Exercise & Delivery
Both Warrants and Stock options are either American, allowing the investor to exercise at any time during the life of the options, or European style, allowing the investor to exercise only during expiration. Warrants issued by the company itself are dilutive. When the warrant issued by the company is exercised, the company issues new shares of stock, so the number of outstanding shares increases. When a call option is exercised, the owner of the call option receives an existing share from an assigned call writer (except in the case of employee stock options, where new shares are created and issued by the company upon exercise). Unlike common stock shares outstanding, warrants do not have voting rights.Remember, the issuers of warrants are the issuing banks directly representing the companies issuing the shares. These companies win as long as their shares get sold and capital raised. This is unlike stock options where the investor selling the options could lose significant amount of money when call options they wrote gets in the money and then subsequently exercised.
Differences on the basis of Trading Strategies
As stock options can be bought or shorted, there are a myriad of hedging and trading strategies that can be used, including credit strategies. As stock warrants can only be bought, it can only be traded like stocks without the flexibility and versatility that stock options can offer.
Conclusion
Even though Warrants share the same trading characteristics of Stock Options, it is really a totally unique trading instrument. Warrants are created more like over-the-counter exotic options where the terms of each warrant is highly customizable to meet the needs of the issuer and then securitized and publicly traded. In fact, the very same warrants that are publicly traded in derivatives exchange are traded in over-the-counter markets (OTC) as well, while in the US, only non-standardized options are traded OTC. In short, warrants are a form of exotic option that are capable of being traded publicly.
Here is a list of main differences between Stock Warrants and Stock Options.
| Stock Warrants | Stock Options | |
| Contract Terms | Defined by issuer | Standardized by exchange |
| Trading | Cannot be freely shorted | Can be shorted |
| Strike Prices | Only those issued | Usually a lot more strike prices and expiration |
| Delivery | Delivered by issuer | Delivered by investors |
Due to these differences, especially the fact that warrants cannot be freely shorted, the hedging possibilities as well as the kinds of options strateiges that can be executed using warrants are a lot lesser than stock options. In fact, the only hedging strategies one can execute with warrants is the Protective Put strategy and delta neutral hedging using put warrants, which acts in almost the exact fashion as a put option.
So far, because Warrants can only be bought and not shorted, it is mainly used by speculators as a form of stock replacement.
One notable instance in which warrants made a big difference to the company and investors took place in the early 1980s when the Chrysler Corporation received governmentally guaranteed loans totaling approximately $1.2 billion. Chrysler used warrants - 14.4 million of them - to "sweeten" the deal for the government and solidify the loans.
Because these loans would keep the auto giant from bankruptcy, management showed little hesitation issuing what they thought was a purely superficial bonus that would never be cashed in. At the time of issuance Chrysler stock was hovering around $5, so issuing warrants with an exercise price of $13 did not seem like a bad idea. However, the warrants ended up costing Chrysler approximately $311 million, as their stock shot up to nearly $30. For the federal government, this "cherry on top" turned quite profitable, but for Chrysler it was an expensive afterthought.
Because these loans would keep the auto giant from bankruptcy, management showed little hesitation issuing what they thought was a purely superficial bonus that would never be cashed in. At the time of issuance Chrysler stock was hovering around $5, so issuing warrants with an exercise price of $13 did not seem like a bad idea. However, the warrants ended up costing Chrysler approximately $311 million, as their stock shot up to nearly $30. For the federal government, this "cherry on top" turned quite profitable, but for Chrysler it was an expensive afterthought.
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