There are significant and very important differences between stock warrants and stock options. Definitions of stock warrants I have found on the web and in books provide a basic description of stock warrants. But, not knowing the differences between a warrant and option can severely impact a warrant trader or investor (and by that I mean not knowing what you are doing can cost you a lot of money!).
The differences arise from the fact that the call options most U.S. investors are familiar with are standardized contracts issued and guaranteed by The Options Clearing Corporation (OCC). Stock warrants, on the other hand, are issued by the underlying company and are not standardized. The result is that there can be major differences in a warrant and call option that may seem to have similar, or even the exact same, terms.
Stock warrants and options can differ in the following areas:
- Strike Price
- Expiration Date
- The Ability to Exercise or Convert
The strike price for stock warrants and equity options is the price at which you can purchase the underlying stock upon delivery of your warrant or option and some dollar amount. For example, a call option with a $10 strike gives the holder the right to buy the stock in return for his option plus $10. A warrant will also have a strike price, but this strike price can differ from an option strike price in several ways.
First, the strike price for a warrant may include not only a cash amount but other securities. In some instances, an underlying common stock will have more than one warrant class, such as a class A warrant and a class B warrant. These warrants will generally have different strike prices and may include in the strike terms a reference to the other warrant.
Using the class A and B example, the strike (or conversion) terms for the class A warrant may read, “One class A warrant plus $10, plus 2 class B warrants, may be converted into one share of stock ABC (the underlying).” Some warrants may have very complex strike terms. (It’s really only simple math, but if you don’t pay careful attention, it can become quite confusing.)
Let’s throw a class C warrant into the mix. The strike terms for the class B warrant could read, “One class B warrant is convertible into 1.548 ABC stock upon delivery of the class B warrant, plus $5.39, plus 6.34 class A warrants and 8.3 class C warrants.” The terms are complex, but where a trader normally has only two instruments to conduct arbitrage, the common and a warrant, he now has 4 instruments (not including any options) that can be traded against each other.
Second, the company issuing the warrants can change the strike terms. Yes, you read that correctly, THE COMPANY CAN CHANGE THE STRIKE TERMS. While you will never wake up to find the strike price changed on your Apple (AAPL) call options, it is possible, and not uncommon, to find your strike terms have changed in a warrant position.
In every instance in which I have seen this take place, the change is in favor of the warrant holder. In other words, the strike price or terms are more favorable because the strike has been reduced. No one complains if the strike price on the warrants they hold moves from a $5 strike to a $3 strike. (For a few reasons why a company might do this, see my upcoming ebook.)
A warrant, like a call option, will also have an expiration date. The warrant must be exercised by this date or it will expire worthless. Call options are issued at specific times for a defined time period. For instance, call options can have weekly, monthly, or longer term time periods (LEAPs) in which they are exercisable. Warrants may be issued at any time, either as part of an IPO, or as a secondary offering, or even as part of litigation concerning the company.
Similar to the price terms of a standard call option, the expiration date for a call option will not change. The expiration date of a warrant, however, can be changed by the issuing company. Again, it is not uncommon for a company to extend the time in which a warrant can be exercised.
A warrant, when exercised, normally results in a cash infusion into the issuing company (unless the exercise is non-cash), and therefore it benefits the company when the warrant is exercised. This is different from a call option which when exercised gives no direct benefit to the company. Retaining the possibility of this cash infusion, from the exercise of warrants at some point in the future, is one reason a company might extend the date and give additional time to exercise the warrant.
Some warrants, unlike call options, can also be “called.” This feature is similar to that often found in a convertible preferred or a callable bond, but with its own nuances. Usually when this is a feature of a warrant, there is some price at which the underlying common stock must trade above in order for the company to call the warrant. These terms are spelled out in the SEC filings necessary to register the warrant.
Ability to Exercise
The most important thing to know about a warrant, other than the expiration date and strike price, is whether or not the warrant is currently exercisable. This is a major difference between warrants and call options, and it can cost even experienced arbitrage traders money. While call options are always exercisable (though from a financial standpoint exercise may not be advisable), warrants are only exercisable if a current registration statement, filed with the SEC, is in effect.
A warrant often has a specified time in which it is not exercisable immediately after issuance. Generally this time runs from three to six months if it is part of the warrant terms. The registration statement will contain these terms.
But, even after this time period expires, a warrant may or may not be exercisable. This can make for a very costly trap for the uninitiated. Imagine you find a warrant with the following terms: one warrant plus $5 is convertible into one share of the underlying common. The warrant is trading at $4 and the common is at $10. JACKPOT! You short the common at $10 and buy the warrant at $4, the equivalent of buying back the stock you just shorted at $10 for $9. That’s ten percent in the bank!
Not so fast Gordon Gecko. If the warrant is not exercisable you’ve just arbitraged nothing. You’re now in a warrant position which is not convertible into the common you’ve shorted. And, if the common begins to rise, which causes a loss in your account, the unexercisable warrant will likely not rise in unison with it. You will lose money as your short position rises and not make that loss up on your long warrant position.
You can make a determination as to whether a warrant is exercisable in a few different ways. First, you can contact your broker who will look up the warrant on a Bloomberg terminal to see if it is listed as exercisable. Second, you can contact the issuing company and ask them if it is exercisable. Third, you can contact The Depository Trust Company (DTC) through which many (but not all) warrants are exercised. If they are the agent charged with converting your warrant they will know if it is exercisable.
Final Thoughts on Stock Warrants vs. Stock Options
While there are other differences between stock warrants and options, these are the major differences which can impact your investing or trading in warrants. It should be clear at this point that these differences are significant and should be thoroughly understood before investing in stock warrants, or engaging in warrant arbitrage. Stock warrants, as non-standardized instruments, can be more complicated than call options. But, putting in a little time to understand the nuances can be a profitable endeavor for either a warrant investor or trader.
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