Stock, or equity, warrants provide a trader or investor the opportunity to use leverage to trade or invest in the fortunes of the underlying company. To often I’ve seen a comparison of two alternative investment vehicles, buying the common stock or buying the warrants. The story always goes the same, if the stock is trading at $10 and the warrant is at $5 (to make our example simple let’s assume the terms are 1 warrant plus $5 gets you one share of common, so we have a warrant trading at parity) and you buy the $5 warrant instead of the common, when the stock is at $12 in two years the warrant will be at $7.
And there you have it, voila, you’ve made 40% on your investment instead of 20%. While that statement is correct, there are other considerations that need to be taken into account. Namely, in this situation the fact that you are using leverage to juice your returns (not that there is anything wrong with that). As long as you aware that your are leveraging your investment, and you have the proper risk management overlay in place, warrants are a great way to introduce leverage into your portfolio.
Unfortunately, most people are not aware that they are using leverage when investing in warrants, and too often investors and traders do not employ proper risk management techniques. The flip side of the “stock is up $2 in two years” is the stock drops $2 in one month, and there you sit with a 40% loss on your trade (though to most it is now definitely an investment).
Warrants trade relative to the underlying. While there will likely be a premium in the price of the warrants, they will still move on some percentage basis relative to the underlying. When you have an arbitrage position on, in which you are short common and long warrants, a move down is advantageous to your position, and will be profitable.
When you are simply long warrants, you have taken on a long position that is leveraged, again, not necessarily a bad thing if the stock moves up, but on a percentage basis you will lose more on your long warrants versus being long the common stock. There are many ways to enter and manage a leveraged position, many of which can be found in the Tharp book referenced here. There may be more than one risk management technique which you find workable, as each trader or investor will have different tolerances for risk in different portions of his portfolio. But the bottom line is that when trading a leveraged instrument it is imperative that you are first aware of the leverage, and secondly that you manage the trade or investment appropriately. Failure to do either can result in an outsized loss of capital, and none of us wants that.