Warrants and options are securities that are related in a lot of ways although they have a few significant differences. Options and warrants both give owners the right, but not the obligation to either buy or sell a principal security at an agreed upon price within a given time.

While a warrant is issued directly by the company or banks that act on behalf of the company, in options the shares are received or given by one investor to another. Unlike stock options, new shares are issued by the company when the stock warrant is created. Warrants are created based on the issuer of warrant and is always fluctuated in such a way that it meets the interest of the issuer. Where in options, no such variables are seen which is one sided.

Within the context of startups, an option is the right to purchase an existing share of a company’s stock from the company at a specific price (typically fair market value of that share on the issue date); whereas a warrant offers the right to purchase a share that will be created in the future.

Why Warrants and Options Are Important

  • Unlimited profit potential and reduction of loss

The best feature of warrants and options to retail investors is that they offer unlimited profit potential and limit any possible loss of the invested money.

  • The leverage

The second key advantage of using option and warrant is their leverage.

However, the greatest issue with warrants and options unlike the principal stock is that they have a limited life and are not entitled for dividend payments.

When to use Options?

The options contract is a financial contract that grants the holder the right, but not the obligation, to either buy or sell a principal security, such as outstanding stocks, at an agreed price within a specified time period.

Options are standardized. They are basically written by either private investors or market makers. They trade on a security exchange just like stocks and are issued by exchanges to facilitate hedging and speculation by investors and traders.

Stock options are typically issued to employees, directors, or service providers in exchange for services. They are used as a reward as the company’s stock price increases.  

When to use Warrants?

Companies issue warrants typically as an inducement for an equity or debt issue. Warrants are also issued to lower financing costs and to help businesses make extra gain if the stock performs well. It gives investors extra participation in the company’s growth. Investors opt for a little lower interest rate on a bond financing attached with a warrant than the one that don’t have warrants attached. Companies often include warrants as part of a new-issue offering to entice investors into buying the new security. A conversion ratio is the number of warrants needed in order to buy or sell an investment unit.

Warrants are highly transparent and transferable. They are high-risk and high-return investment tools more attractive for medium to long-term investment options and to private investors, speculators and hedgers.

Difference between Warrants and Options

Although warrants and options are very similar in many aspects, the two differ considerably and it is significant to recognize these differences and what they mean before you use them as investment tools.

The major differences between warrants and options are specified below:

  • Issuer: Warrants are issued by a specific company, while options are issued by an options exchange like the U.S. Chicago Board Options Exchange.

  • Maturity: Warrants usually have longer maturity periods than options. The longest term for options is two years while that of warrants can last as long as 15 years.

  • Dilution: Warrants results to dilution and issue of new stock while options don’t involve issuing new stock.

  • Pricing model: The pricing model used by option is different from the pricing model used in warrant. The model for pricing warrant is a customized version of the model for pricing option. It makes use of dilution and gearing. Gearing is the ratio of the stock price to the price of warrant. It represents the leverage offered by the warrant. The value of the warrant is directly proportional to its gearing.

  • SEC Registration: A warrant cannot be exercised unless you have registered with the SEC. An option doesn't require registration for those who are exempt.

  • Standardized and non-standardized contract: Option contracts are standardized. All options must therefore comply with rules specified by exchanges like the duration, size, exercise price and trading unit while warrants are more flexible. As a result of this, there are different types of warrants and each of them has different maturity time, exercise prices, contract sizes and parities.

  • Underlying values: Warrants are issued on different types of security like currencies; international shares whereas the options market focuses on domestic shares, indices and bonds.

  • Profits: Warrants are issued by companies to encourage the sale of shares and to hedge against a reduction in the value of the company which may result due to a drop in the share price of the company. Thus, when you buy a warrant, you are helping the company issuing it no matter if it gets exercised or not. However, in a stock option transaction, the company does not receive any direct benefit rather the benefit goes to the winning investor.

  • Tax rules: The tax rules governing options and warrants are completely different. Stock options are compensatory in nature and therefore subject to the rules governing compensatory items. Warrants on the other hands are not compensatory and are generally taxed.

  • Ownership: Warrants are owned by investors, partners or companies while options are owned by employees.

Further differences between options and warrants are:

  • Options are standard contracts while warrants are securities.

  • Options trading follow the principles of a futures market, while warrants trading follow the principles of a cash market.

  • The terms of options are set by the equity exchanges where they are traded whereas the terms of warrants are set by the issuer.

  • In options trading, the selling party writes the option while warrants have one single issuer who is responsible for the right offered by warrants. Warrants are issued by private parties, instead of a public exchange.

  • There are margin calls in options whereas warrants have no margining or margin calls.

  • Unlike Options, warrants are dilutive and are considered over the counter instruments

  • Investors cannot write warrants but can write options.

  • Warrants are not issued independently but together with other instruments like bonds whereas options can be issued independently.

  • Options can be bought or written or shorted and involves the use of many hedging and trading strategies. Warrants cannot be freely shorted like options and are mainly used by speculators to replace stock due to possible hedging.

  • The forms of trade strategies that can be executed with warrants are much lesser than stock options

  • The contract booklet to be signed in both option and warrants are different.

  • Unlike option, the holder of a warrant sells back to the issuing company instead of to another trader or investor.

Similarities

  • Both options and warrants offer their holders the chance to gain exposure to the rise and fall in price of the principal asset, without possessing the asset.

  • Both are financial instruments, which confer on their holders the right to purchase a specific quantity of principal asset or an indicator at a fixed price and at a specific date.

  • Both Options and warrants represent a right and do not provide any control over the principal asset until exercised.

  • Like warrants, options have a lifetime, an expiration date and an exercise price, and their prices depend on the same factors and develop in the same way as warrant prices.

  • Basic components: Both options and values have 2 equivalent basic components known as the – intrinsic value and time value. Intrinsic value for a warrant or option is the difference between the price of the principal stock and the exercise or strike price. The exercise or strike price is the amount that must be paid in order to either buy a call warrant or sell a put warrant.

    • The intrinsic value can be zero, but it can never be negative. Time value is the difference between the price of the option or warrant and its intrinsic value. Time value shows the likelihood of the stock trading beyond the strike price by option expiry.

  • Influencing factors: Factors that influence the value of an option or warrant are the same. Examples of such factors are: underlying stock price, strike price or exercise price, time to expiry, implied volatility and risk-free interest rate.

Types of options:

  • Call options and;

  • Put options.

Call options give the holder the right to buy the underlying security and Put options give the holder the right to sell the underlying security.

Advantages of Options Over Warrants

Despite the similarities between option and warrants, options are more preferred as a trading strategy than warrants for the following reasons:

  • It is possible to create spreads through buying and writing of options contracts.

  • The number of trading strategies that involves warrant is insignificant compared to option.

  • It is much easier to buy and sell options because they are traded on public exchanges; warrants on the other hand are sold over the counter.

  • Options are more versatile than warrants.

Types of Warrants

There are two different types of warrants. These are:

  • A call warrant and;
  • A put warrant

A call warrant represents a specific number of shares that can be purchased from the issuer at a specific price, on or before a certain date. A put warrant represents a certain amount of equity that can be sold back to the issuing company at a specified price, on or before a stated date. European style warrant is more common than the American style warrant. The extrinsic value of European style warrants is much lower than that of American style.

Features of a Warrant

Warrant certificates contain specific particulars of the investment tool they represent. Some those features are:

  • Specific expiry date,

  • Specific exercise style like if it is an American exercise style or a European exercise style of warrant.

  • The inclusion of principal asset on warrant certificates.

  • The warrants certificate could be issued on shares, a commodity, index or a currency.

Advantages of warrants over Options

There are benefits and risks attached to warrants:

  • 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.

  • Warrants are often attached to bonds in order to make the bonds a more attractive option for investors

  • Warrants generally exaggerate share price movements in terms of percentage change.

  • 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.

  • Warrants can offer a smart addition to an investor's portfolio

  • Warrants are investment option that can offer small scale investor the opportunity for diversity without competing with giants.

Disadvantages of warrants

There are some risks involved in warrants like any other investment option:

  • The leverage and gearing warrants offer can be high and this can as well work to the disadvantage of the investor.

  • The value of the certificate can drop to zero and if happen prior to the exercise the redemption value is lost.

  • A holder of a warrant does not have any voting, shareholding or dividend rights.

Substance Over Form

The choice to use an option or warrant totally depends on law guiding securities. Most instruments will clearly be regarded as either options or warrants depending on what the issuer have in mind. You cannot alter the name of the instrument simply because you believe option or warrant treatment is more favorable.

Conclusion

Options are compensatory vehicle while warrants are not for compensation but are mainly issued to help the company raise capital, either debt or equity securities, and to improve the deal for the investor. While warrants and options are beneficial to investors they also have their risks. Investors should thus understand these financial instruments and consider the tax consequences before making use of them.

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