Warrants and call options (options to buy)

Warrant vs option

Warrants and call options (options to buy) are similar securities in many respects, but they also have a few significant differences.

A warrant is a security that provides the holder with the right, but not the obligation, to purchase one ordinary share directly from the company at a fixed price over a predetermined period of time.

Like warrants, a call option (option to buy) also provides its holder with the right, without obligation, to purchase one ordinary share at a fixed price over a predetermined period of time.

So, what are the differences between these two trading instruments?

 

The difference between warrants and call options

  • Issuer: warrants are issued by specific companies, while options exchanged in a market are issued by an options exchange such as the Chicago Board Options Exchange in the United States. Options are therefore more standardised in some aspects such as the expiration period and the number of shares per option contract (usually 100).
  • Maturity: warrants have maturity periods that are greater than those of options. Warrants typically expire after one to two years and can sometimes have maturities well beyond five years. Call options have maturities ranging from a few weeks or months to one or two years, and longer term options may not be very liquid.
  • Dilution: warrants cause dilution because a company is required to issue new shares when a warrant is exercised. Exercise of a call option does not involve the issue of new shares because a call option is a derivative instrument of an existing ordinary share of a company.

 

Why are warrants and call options issued?

Warrants are a sort of "extension" of a stock or a bond (debt issuance). Investors like warrants because they offer additional participation in a company's growth. Companies include warrants in shares or bonds in order to lower financing costs and to provide additional capital insurance in the event that the share price is favourable. In addition, investors are more likely to opt for a slightly lower interest rate on bond financing if a bond is backed by a warrant.

Options traded on the stock market meet certain criteria, such as share price, the number of shares outstanding or the distribution of the average daily volume. Stock options facilitate hedging and speculation for investors and traders.

 

Examples

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

  • Strike price: the price at which the buyer of a warrant or a call option has the right to buy the underlying asset. "Strike price" is the preferred term to use when referring to warrants.
  • Expiration: the limited time period during which the warrant or option may be exercised.
  • Price of the option or premium: the price to be paid in order to acquire a warrant or an option.

Warrant

For example, let's consider a warrant with an exercise price of $5 a share that is trading at $4 a share. The warrant expires in 1 year and is currently priced at 50 cents. If the underlying share trades at more than $5 during the 1-year expiration, the price of the warrant will increase accordingly. Let's imagine that just before the warrant's 1-year expiration, the underlying share's price rises to $7. The warrant will then have a value of at least $2 (the difference between the price of the share and the warrant's exercise price). And conversely, if the price of the underlying share drops below $5 just before the warrant expires, the warrant will have very little value.

A trade with a call option is very similar. A call option that expires in one month with an exercise price of $12.50 a share that is trading at $12 will see its price fluctuate along with the underlying share. If the stock is trading at $13.50 just before the option expires, the call will be worth at least $1. Conversely, if the stock is trading at or below $12.50 when the call option expires, the option will expire with no value and the investor will have lost the premium paid to purchase the option.

 

Intrinsic value and time value

The same variables influence the price (premium) needed to buy a call option or a warrant, but other additional factors can affect the price of a warrant. First, let us explore the two basic components of the value of a warrant and an option - the intrinsic value and the time value.

The intrinsic value of a warrant or a call option is the difference between the price of the underlying security and the exercise price or strike price. Intrinsic value may be zero, but it can never be negative. For example, if an underlying share is trading at $10 a share and the exercise price of a call option is $8, the intrinsic value of the option is $2. If the stock is trading at $7 a share, the intrinsic value of the option is zero. (The price of the underlying security - strike price = intrinsic value.)

The time value is the difference between the price of a warrant or a call option and its intrinsic value. For the above example of a trade with a share at $10 and an exercise price of $7, if the option price is $2.50 and the intrinsic value is $2, then the time value is equal to 50 cents. The price of an option with no intrinsic value entirely consists of its time value. The time value represents the ability to trade a share above the strike price upon the expiration of the option. (The price of option's "premium" - intrinsic value = time value.)

 

The price or the premium

The factors that influence the price of a call option or a warrant are:

  • Price of the underlying share: the price of an option or a warrant increases when the price of the underlying share increases.
  • Exercise price or strike price: the lower the strike price is, the higher the price of the call option or warrant will be. Why? Because the investor pays more for the right to buy an asset at a price that is lower than the price of the underlying asset.
  • Time until expiration: the price is highest when it is furthest away from the expiration date.
  • Implied volatility: the price increases when volatility is high, because the option has a greater probability of being profitable if the underlying asset is more volatile.
  • Risk-free interest rate: the higher the interest rate, the higher the price of the warrant or option will be.

The Black-Scholes model is the one most often used to price options, while a modified version of this model is used to price warrants. Using a calculator, the values of these variables can be used to obtain the price of an option. As the other variables are more or less fixed, the estimate of implied volatility becomes the most important variable in the pricing of an option.

The price of a warrant is slightly different because it must take into account the dilution mentioned above and its "gearing". Gearing is the ratio between the share price and the price of a warrant; it represents the leverage effect that a warrant offers. The value of a warrant is directly proportional to its gearing.

The function of dilution makes a warrant slightly less expensive than an identical call option, by a factor of (n / n+w), where "n" is the number of shares outstanding and "w" is the number of warrants. For example, for 1,000,000 shares and 100,000 warrants outstanding, if a call option on that stock is trading at $1, the same warrant (with the same maturity date and strike price) will be worth around 91 cents.

 

Examples of trades with warrants or call options

The biggest advantage of using warrants and call options is that these trading instruments offer unlimited earning potential, while minimizing the possible loss of the amount invested. The other major advantage is their leverage.

Their main disadvantages are that unlike the underlying share, they have a limited life and are not eligible for dividend payments.

Consider an investor who has a high tolerance for risk and $2,000 to invest. The investor has the choice between investing in a share worth $4, or investing in a warrant on the same share with an exercise price of $5. The warrant expires in 1 year and is currently priced at 50 cents. The investor is very optimistic about the share and in order to profit the most from its increase in price, he decides to only invest in warrants. He therefore buys 4,000 warrants (4,000 x $.50 = $2,000) on the share. If the share appreciates to $7 after approximately 1 year (meaning, right before the warrants expire), each warrant will have a value of $2, a total of $8,000, representing a gain of $6,000 or +300% compared with the initial $2,000 investment. If the investor had instead chosen to invest directly in the share, the return on investment would have been only $1,500 or +75% compared with the initial investment.

Of course, if the share had closed at $4.50 right before the expiration of the warrants, the investor would have lost 100% of his initial $2,000 investment in the warrants, as opposed to a gain of +12.5% had he invested in the share instead.

 

Conclusion

Warrants are very popular in some markets such as Canada and Hong Kong. In Canada, for example, it is common practice for natural resource companies that seek funding for exploration to do so through the sale of units. Each unit consists of one common share that is delivered with a half warrant, which means that two warrants are required to purchase 1 additional common share. (Note that several warrants are often required in order to purchase 1 share at the exercise price.) These companies also offer "broker warrants" to their subscribers, in addition to cash commissions, as part of the compensation structure.

Warrants and call options offer significant benefits for investors, but these derivatives are not without risks. Investors should therefore carefully consider these versatile instruments before using them in their stock portfolios.

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