Miscellaneous stock options warrants

Warrants, Options, Derivatives, and Rights.

These are all different types of high risk investments, and we highly discourage traders from getting involved with them. Most inexperienced traders lose a lot of their money trying to learn the ropes, only to find that most experienced traders are also losing money with these.

The true purpose of options and derivatives is for use in advanced hedging strategies.

Warrants and rights are generally given to directors of companies as compensation or incentives.

While you can make money on these types of investments, you should also realize that this is a game for very experienced traders that are applying hedging strategies or have a stake in the underlying company.

You could also make money playing roulette, but in most cases you will lose. I could not suggest with good conscience that you get involved in such trading vehicles.

Having read all of the methodologies and concepts presented within this website, you are now an insider into the world of penny stocks. You have the advantage in this field, so why start looking elsewhere?

The penny stock markets will present greater profit opportunities with lower risk than options, derivatives, warrants, and rights.

Differences Between Warrants & Options.

Differences Between Warrants & Options - Introduction.

Stock options and Stock warrants are two extremely popular derivative instruments that are traded in stock and derivative exchanges all over the world.

Differences Between Warrants & Options - 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. Read our Stock Options Tutorial for full explanations. 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.

Differences Between Warrants & Options - 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.

Differences Between Warrants & Options - 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 Between Warrants & Options - Exercise & Delivery.

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 are only European style, which are automatically exercised during expiration if they are in the money. 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 Between Warrants & Options - Pricing.

Because warrants are European style only, it's extrinsic value is significantly lower than that of American style stock options. American style stock options have higher extrinsic value due to the added benefit of allowing the holder to exercise the options at anytime during the life of the stock options. The higher extrinsic value of american style options makes credit strategies much more profitable than European ones.

Differences Between Warrants & Options - 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. Get a full list of Options Strategies.

Differences Between Warrants & Options - 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.

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.

How are stock warrants different from stock options?

A stock option is a contract between two people that gives the holder the right, but not the obligation, to buy or sell outstanding stocks at a specific price and at a specific date. Options are purchased when it is believed the price of a stock will go up or down (depending on the option type). For example, if a stock currently trades at $40 and you believe the price will rise to $50 next month, you would buy a call option today so that next month you can buy the stock for $40, then sell it for $50, and make a profit of $10. Stock options trade on a securities exchange, just like stocks.

A stock warrant is just like a stock option because it gives you the right to purchase a company's stock at a specific price and at a specific date. However, a stock warrant differs from an option in two key ways:

A stock warrant is issued by the company itself New shares are issued by the company for the transaction.

Unlike a stock option, a stock warrant is issued directly by the company. When a stock option is exercised, the shares usually are received or given by one investor to another. When a stock warrant is exercised, the shares that fulfill the obligation are not received from another investor, but directly from the company.

Companies issue stock warrants to raise money. When stock options are bought and sold, the company that owns the stocks does not receive any money from the transactions. However, a stock warrant is a way for a company to raise money through equity. A stock warrant is a smart way to own shares of a company because a warrant usually is offered at a price lower than that of a stock option. The longest term for an option is two to three years, while a stock warrant can last for up to 15 years. So, in many cases, a stock warrant can prove to be a better investment than a stock option if mid - to long-term investments are what you seek.

Warrants And Call Options.

Warrants and call options are both types of securities contracts. A warrant gives the holder the right, but not the obligation, to buy common shares of stock directly from the company at a fixed price for a pre-defined time period. Similarly, a call option (or “call”) also gives the holder the right, without the obligation, to buy a common share at a set price for a defined time period. So what are the differences between these two?

Similarities Between Warrants and Call Options.

The basic attributes of a warrant and call are the same:

Strike price or exercise price – the guaranteed price at which the warrant or option buyer has the right to buy the underlying asset from the seller (technically, the writer of the call). “Exercise price” is the preferred term with reference to warrants. Maturity or expiration date – The finite time period during which the warrant or option can be exercised. Option price or premium – The price at which the warrant or option trades in the market.

For example, consider a warrant with an exercise price of $5 on a stock that currently trades at $4. The warrant expires in one year and is currently priced at 50 cents. If the underlying stock trades above $5 at any time within the one-year expiration period, the warrant’s price will rise accordingly. Assume that just before the one-year expiration of the warrant, the underlying stock trades at $7. The warrant would then be worth at least $2 (i. e. the difference between the stock price and the warrant’s exercise price). If the underlying stock instead trades at or below $5 just before the warrant expires, the warrant will have very little value.

A call option trades in a very similar manner. A call option with a strike price of $12.50 on a stock that trades at $12 and expires in one month will see its price fluctuate in line with the underlying stock. If the stock trades at $13.50 just before option expiry, the call will be worth at least $1. Conversely, if the stock trades at or below $12.50 on the call’s expiry date, the option will expire worthless.

Differences Between Warrants and Call Options.

Three major differences between warrants and call options are:

Issuer : Warrants are issued by a specific company, while exchange-traded options are issued by an exchange such as the Chicago Board Options Exchange in the U. S. or the Montreal Exchange in Canada. As a result, warrants have few standardized features, while exchange-traded options are more standardized in certain aspects, such as expiration periods and the number of shares per option contract (typically 100). Maturity : Warrants usually have longer maturity periods than options. While warrants generally expire in one to two years, they can sometimes have maturities well in excess of five years. In contrast, call options have maturities ranging from a few weeks or months to about a year or two; the the majority expire within a month. Longer-dated options are likely to be quite illiquid. Dilution : Warrants cause dilution because a company is obligated to issue new stock when a warrant is exercised. Exercising a call option does not involve issuing new stock, since a call option is a derivative instrument on an existing common share of the company.

Why are Warrants and Calls Issued?

Warrants are typically included as a “sweetener” for an equity or debt issue. Investors like warrants because they enable additional participation in the company’s growth. Companies include warrants in equity or debt issues because they can bring down the cost of financing and provide assurance of additional capital if the stock does well. Investors are more inclined to opt for a slightly lower interest rate on a bond financing if a warrant is attached, as compared with a straightforward bond financing.

Warrants are very popular in certain markets such as Canada and Hong Kong. In Canada, for instance, it is common practice for junior resource companies that are raising funds for exploration to do so through the sale of units. Each such unit generally comprises one common stock bundled together with one-half of a warrant, which means that two warrants are required to buy one additional common share. (Note that multiple warrants are often needed to acquire a stock at the exercise price.) These companies also offer “ broker warrants” to their underwriters, in addition to cash commissions, as part of the compensation structure.

Option exchanges issue exchange-traded options on stocks that fulfill certain criteria, such as share price, number of shares outstanding, average daily volume and share distribution. Exchanges issue options on such “optionable” stocks to facilitate hedging and speculation by investors and traders.

Intrinsic Value and Time Value.

While the same variables affect the value of a warrant and a call option, a couple of extra quirks affect warrant pricing. But first, let’s understand the two basic components of value for a warrant and a call – intrinsic value and time value.

Intrinsic value for a warrant or call is the difference between the price of the underlying stock and the exercise or strike price. The intrinsic value can be zero, but it can never be negative. For example, if a stock trades at $10 and the strike price of a call on it is $8, the intrinsic value of the call is $2. If the stock is trading at $7, the intrinsic value of this call is zero. As long as the call option's strike price is lower than the market price of the underlying security, the call is considered being "in-the-money."

Time value is the difference between the price of the call or warrant and its intrinsic value. Extending the above example of a stock trading at $10, if the price of an $8 call on it is $2.50, its intrinsic value is $2 and its time value is 50 cents. The value of an option with zero intrinsic value is made up entirely of time value. Time value represents the possibility of the stock trading above the strike price by option expiry.

Valuation of Call Options and Warrants.

Factors that influence the value of a call or warrant are:

Underlying stock price – The higher the stock price, the higher the price or value of the call or warrant. Call options require a higher premium when their strike price is closer to the underlying security's current trading price, because they're more likely to be exercised. Strike price or exercise price – The lower the strike or exercise price, the higher the value of the call or warrant. Why? Because any rational investor would pay more for the right to buy an asset at a lower price than a higher price. Time to expiry – The longer the time to expiry, the pricier the call or warrant. For example, a call option with a strike price of $105 may have an expiration date of March 30, while another with the same strike price may have an expiration date of April 10; investors pay a higher premium on call option investments that have a greater number of days until the expiry date, because there's a greater chance the underlying stock will hit or exceed the strike price. Implied volatility – The higher the volatility, the more expensive the call or warrant. This is because a call has a greater probability of being profitable if the underlying stock is more volatile than if it exhibits very little volatility. For instance, if the stock of company ABC frequently moves a few dollars throughout each trading day, the call option costs more as it is expected the option will be exercised. Risk-free interest rate – The higher the interest rate, the more expensive the warrant or call.

Pricing Call Options and Warrants.

There are a number of complex formula models that analysts can use to determine the price of call options, but each strategy is built on the foundation of supply and demand. Within each model, however, pricing experts assign value to call options based on three main factors: the delta between the underlying stock price and the strike price of the call option, the time until the call option expires, and the assumed level of volatility in the price of the underlying security. Each of these aspects related to the underlying security and the option affects how much an investor pays as a premium to the seller of the call option.

The Black-Scholes model is the most commonly used one for pricing options, while a modified version of the model is used for pricing warrants. The values of the above variables are plugged into an option calculator, which then provides the option price. Since the other variables are more or less fixed, the implied volatility estimate becomes the most important variable in pricing an option.

Warrant pricing is slightly different because it has to take into account the dilution aspect mentioned earlier, as well as its “gearing". Gearing is the ratio of the stock price to the warrant price and represents the leverage that the warrant offers. The warrant's value is directly proportional to its gearing.

The dilution feature makes a warrant slightly cheaper than an identical call option, by a factor of (n / n+w), where n is the number of shares outstanding, and w represents the number of warrants. Consider a stock with 1 million shares and 100,000 warrants outstanding. If a call on this stock is trading at $1, a similar warrant (with the same expiration and strike price) on it would be priced at about 91 cents.

How to Profit from Calls and Warrants.

The biggest benefit to retail investors of using warrants and calls is that they offer unlimited profit potential while restricting the possible loss to the amount invested. A buyer of a call option or warrant can only lose his premium, the price he paid for the contract. The other major advantage is their leverage: Buyers are locking in a price, but only paying a percentage up front; the rest is paid when they exercise the option or warrant (presumably with money left over!).

Basically, you use these instruments to bet whether the price of an asset will increase – a tactic known as the long call strategy in the options world.

For example, say shares of company ABC are trading at $20 and you think the stock price will increase within the next month: Corporate earnings will be reported in three weeks, and you've a hunch they're going to be good, bumping up the current earning per share (EPS). So, to speculate on that hunch, you purchase one call option contract for $100 shares with a strike price of $30, expiring in one month for $0.50 per option, or $50 per contract. This will give you the right to purchase shares for $20 on or before the expiration date. Now, 21 days later, turns out you guessed correctly: ABC reports strong earnings and raised its revenue estimates and earnings guidance for the next year, pushing the stock price to $30. The morning after the report, you exercise your right to buy 100 shares of company stock at $20 and immediately sell them for $30. This nets you $10 per share, or $1,000 for one contract. Since the cost was $50 for the call option contract, your net profit is $950.

Buying Calls vs. Buying Stock.

Consider an investor who has a high tolerance for risk and $2,000 to invest. This investor has a choice between investing in a stock trading at $4, or investing in a warrant on the same stock with a strike price of $5. The warrant expires in one year and is currently priced at 50 cents. The investor is very bullish on the stock, and for maximum leverage decides to invest solely in the warrants. She therefore buys 4,000 warrants on the stock. If the stock appreciates to $7 after about a year (i. e. just before the warrants expire), the warrants would be worth $2 each. The warrants would be altogether worth about $8,000, representing a $6,000 gain or 300% on the original investment. If the investor had chosen to invest in the stock instead, her return would only have been $1,500 or 75% on the original investment.

Of course, if the stock had closed at $4.50 just before the warrants expired, the investor would have lost 100% of her $2,000 initial investment in the warrants, as opposed to a 12.5% gain if she had invested in the stock instead.

Other drawbacks to these instruments: Unlike the underlying stock, they have a finite life and are ineligible for dividend payments.

The Bottom Line.

While warrants and calls offer significant benefits to investors, as derivative instruments they are not without their risks. Investors should therefore understand these versatile instruments thoroughly before venturing to use them in their portfolios.