What are Stock Warrants? How do they Work?

Stock Warrants from Kinder Morgan

Sample Stock Warrant

Often you might come across stock warrants and you might have wondered what does it mean. Even if you are not interested in buying the warrants, it is important to know if the company that you are interested in buying the stock in also has outstanding warrants, as the warrants can have disproportionate effect on the returns you may be able to realize from the stock itself. To understand why this is the case, it is critical to understand what is a stock warrant and how it works. There are similarities between warrants and options but they also differ in some key respects

Difference between Stock Warrants and Options

If you have stock options awarded to you through your employer, you have the basic idea of how these options work. If you invest in publicly traded options then you have even better idea of how the options work. Warrants are similar to the options, but with one critical difference.

Just like an option, a stock warrant is issued with a “strike price” and an expiration date. The strike price is the price at which the warrant becomes exercisable or “in the money”. Both the warrants and the options eventually expire, if they are not exercised by a certain date.

The Key Difference Between Warrants and Options

Publicly traded options are created by the exchanges and are backed by the stock that already trades in the secondary market (the stock that is already issued that most of us buy and sell – as opposed to the primary market stock issue such as an IPO). When a Call Option is exercised, for example, the required amount of stock from the secondary market is purchased at the strike price.

Stock warrants on the other hand are issued directly by the company and they may trade on the exchanges or over the counter. When a warrant is exercised, the stock that is purchased upon exercising the warrants needs to be issued new by the company. These are not the shares that trade on the secondary market.

So you can see, exercising an option has no effect on the total number of common stock shares outstanding, whereas exercising a warrant increases the total number of common stock shares outstanding.

Stock warrants can also be long term, expiring far in the future while the options are typically short term instruments, expiring within the year (LEAPS are long term options but they are typically only available for a few selected stocks).

If you own common stock in a company that also has warrants outstanding, any exercise of the warrants will increase the number of outstanding shares thereby diluting the existing shareholders. This dilution is more pronounced when warrants are exercised, compared to say, the company issuing new shares on a follow on offering since any follow on offering is typically done close to the market price of the shares, while the exercise of the warrants are typically done below the market price of the shares.

Example of a Warrant

Consider a hypothetical warrant with a strike price of $25 and an expiration date of June 1, 2020. Let’s say the shares of the company currently trade at $5/share. We will take 3 dates with hypothetical stock prices and review how the warrants will behave on those dates and prices.

Situation 1: Today, Stock Price = $5/share

Since the stock price today is $5 and the warrants have a strike price of $25, exercising the warrants today does not make sense. It will force the warrant holder to purchase new stock at $25/share while the stock can just be bought in the secondary market at $5/share. Therefore, the warrants will not be exercised. The warrants will also have very little value because they are so far “out of money”.

The warrants will still have some value. This value comes from the fact that the warrant does not expire for another 8 years and it is likely that the stock price might exceed $25/share at some point during the next 8 years. Just like options, the value of the warrants can be calculated by using the Black Scholes method. Let’s assume, for the sake of the example, that the value of the warrants is $0.25

Situation 2: June 1 2016, Stock Price = $30/share

If the stock price has risen to $30/share by June 1, 2016 the value of the warrants is at least $5. This is because the warrant holders are now able to exercise the warrants, buy the stock at $25 and sell it back in the market at $30 for a $5 profit. Knowing this the market moves to bid up the price of the warrant until the possibility of profiting by just buying the warrant and exercising it right away disappears.

Note that if an investor buys the warrant on June 1 2016, and immediately flips it by exercising it and selling the resulting stock, he will not make any profit. In fact, he may end up with a loss since the price of the warrant is likely to be more than $5 (there are 4 more years remaining before the warrants expire and the probability that the stock price might move higher than $30 in that time gives the warrant additional value).

However, if the investor bought the warrants 4 years ago and paid very little for it, this is a great time to sell the warrants or exercise them. In this scenario, the investor in the warrants may end up with a profit of $5 – $0.25 = $4.75 or 1900%. The stock only went up by $30 – $5 = $25 or 500%.

Situation 3: June 1 2020, Stock Price = $25 or less

The warrants will expire worthless since there is no possibility of profiting by exercising the warrants. Note that the stock may have fallen only 17% since June 1, 2016 but the value of the warrants have declined by 100%.

As this example shows, the Warrants are highly leveraged and magnify the gains or losses on the stock. Therefore they should be used with care and unless you are a professional options trader and are comfortable with the risk, you should keep your exposure to the warrants to a small part of your portfolio.

That being said, warrants do have a role to play in an investor’s portfolio. They can be a way of controlling larger amount of stock with using a less capital than if you buy the stock directly. They can also be used for hedging purposes, similar to options.

And sometimes, the stock may not be undervalued but the stock warrants may be since warrants are not as popular with investors as the common stock. In those situations, it may offer the possibility of a risk free arbitrage.

Here is a real life example of a stock warrant that we bought and sold over the course of 1 year. These warrants were originally issued by Real Opportunity Investments Corp as an incentive for the investors to purchase their stock. The warrants have now expired.

Comments

  1. Matthew Cullen says

    What does forced redemption and cashless exercise mean? Why would a company want to do either of these….this question stems from Hemisphere Media (HMTV and HMTVW)…..from their most recent prospectus:

    Each warrant entitles the holder to purchase one-half of one share of our Class A common stock at a price of $6.00 per half share. At March 31, 2015, 14.7 million warrants were issued and outstanding, which are exercisable into 7.3 million shares of our Class A common stock. At the option of the Company, 10.0 million warrants may be called for redemption, provided that the last sale price of our Class A common stock reported has been at least $18.00 per share on each of twenty trading days within the thirty-day period ending on the third business day prior to the date on which notice of redemption is given. The warrants expire on April 4, 2018.

    Thanks
    Matthew

    • says

      Warrants are typically issued along with equity as a sweetener to parties who are not very comfortable with the equity alone. Essentially what the company is saying is that to assuage some of your reservations, we will throw in a kicker in the form of warrants along with the equity. However, if the equity price goes beyond a certain level and stays there, we would have delivered appropriate level of return on the equity and the warrants would no longer be necessary.

      At a practical level, existence of warrants serves as a dampener on the stock price (since as warrants are exercised, new stock is issued). The primary responsibility of the management is to the shareholders, and therefore once the warrants become unnecessary, the company would like to remove them from circulation.

  2. Tony says

    Question?

    I’m trying to understand if the expiration of a warrant is a positive thing or a negative thing for a particular company. Below are the press release and my question. Thank you in advance for your help.

    07.21.2015 | Press Release
    Liquidmetal Technologies Announces Expiration of 30 million warrants

    My question is can these share be reissued at a lower exercise price and if so must shareholders vote for this to happen or can management just reissue the shares, which obviously would cause more dilution due to the PPS being much lower today than when the shares were issued?

    I haven’t had time yet to fully research the meaning of the press release from today, but these are my concerns. Would you please help me clarify or tell me where to look to confirm.

    I’m seeing this from two different perspectives. 1) (Positive) Meaning these shares (30M) can no longer be exercised at the exercise price of: between $0.48 and $0.49. 2) (Negative) if these shares are able to be reissued and purchased by insiders at the current PPS of .1380 this is not a good thing.

    • says

      Tony, it just means that the warrants will cease to exist and therefore the potential for 30 million new shares being issued (as the warrants are exercised) goes away. This would be a positive for the share holders as the risk of dilution is no longer there. This would be negative for the warrant holders as their warrants will have no value in the future.

  3. Dean says

    I am attempting to understand warrants. I currently hold 115 AIG.WS warrants. The option price is $45 set to expire in approx 6 years. The warrant value has well surpassed the AIG value. For it to be worth while to exercise on the $45 option, would it not be necessary for the sum of the Warrant value, currently $27.51, plus the $45 option cost to be less than the current AIG stock value of $62.94, which it is but only by $0.43? Would there also be the benefit of a dividend on the AIG holding, should one be issued? Also, in the case of a split, are the warrants unaffected by the split? Thank you.

    • says

      Dean, the warrant prices may at times lag or lead the stock price so you will see small variances open up ($0.43 in this case). If there is a long time left for expiration, in this case you have 6 years, than the variance can be large as it also reflects the probability that the stock price for AIG would be at a different level in 6 years than today (similar to your normal Black Scholes model for option pricing)

      Warrant holders are at a disadvantage if there are dividends paid on the AIG equity, as the exercise price is not adjusted for the dividend.

      In case of a split, the warrant exercise price should be adjusted to reflect the split.

  4. Lukasz Wicher says

    I wanted to get some info on warrants and what happens to out of money warrants in the event of a buyout or merger. Do they simply remove themselves or are the terms adjusted.

    Thanks,
    Lukasz

    • says

      Depends. If the warrants are for the acquiring company, they should not be affected. If the warrants are for the company that is being acquired, they will be nullified unless special provisions are made in the merger agreement.

      Regards,
      Shailesh

  5. Balbir says

    Hello Mr. Kumar.
    I never tried to understand warrants until a foreign stock I currently hold recently issued 1 warrant for every 10 shares owned. I now see the added line for these warrants in my portfolio (online), but there is no mention of the warrant’s strike price or expiration date as you mentioned above. Is this because they were bonus warrants? How would I determine the missing info above in order to better understand or plan its eventual exercise?
    Thanks in advance

    • says

      Hi Balbir,

      The company should have filed some paperwork with the securities regulator (e.g SEC filings) describing the warrant. This should have the details. If this is hard to find, often times the companies list all the warrants and details in their Annual Reports (may not do it in quarterly or semi annual reports).

      Regards.

  6. Alex says

    Hi Mr Kumar,

    I’m not clear on the subject as I am new to investing, but I came across the option to buy TACOW for $6 or TACO for $16, the merger will complete mid june/ early july. What’s the difference? What will happen if I buy either one?

    Thanks for your time.

  7. Jimmy says

    If an investor has a warrant—for example—they received in a transaction in December 2013, would exercising today reset the purchase date to today? Meaning would this reset the clock on achieving long-term tax status? Or would the original December 2013 purchase date carry over?

    • says

      Hi Jimmy,

      Yes, exercising the warrant resets the purchase date to the date of exercise. At the same time, the cost basis is reset to equal the cost basis in the warrant + the price paid to acquire stock in the exercise.

      On the other hand, if the warrants were sold and not exercised, they would have carried the original purchase date and cost basis.

      Please note that this is with the US tax laws. Other jurisdictions may treat this differently.

      Regards,
      Shailesh

  8. John says

    Hello, I own a stock. An insider just exercised 3Millions warrants (at 0,60$ and they would have expired in 6 months, the current shareprice is 1,50$). He has not sell any share after that. What is his benefit to exercise it now if it’s not for selling it now?

    • says

      Hi, maybe he just wants to hold the stock as ownership in the company and wait for the stock to appreciate if he thinks the company is doing well. This is better than letting the warrants expire as then he would have no value left.

      • John says

        Thank you for your prompt response. The warrants would have expired in 6 months, no need to exercise them now. I see two possibilities, he wants to have more vote in case of a buyout (the company is in a quiet period right now), or he wants to sell it quickly when the quiet period will be over (I am not sure if he could sell the shares at the same time he exercise the warrants?). Does it make sense, should I read it negatively or positively? Hard to say!

  9. says

    Hi MR.KUMAR
    I need your Advice Urgently
    Which Of The Three $lEVY $lEVYW $LEVYU Would You Choose To Hold On TOO?
    I Need to Make A Decision ASAP
    Appreciated…
    Much Respect
    Joe,Gallo

    • says

      Hi Joe,

      I would hold on to LEVYW to maximize my gains in the shortest time. The same investment thesis will hold true for all 3 instruments. The only thing to keep in mind is that you will need to sell LEVYW in case LEVY stock gets close to $24/share as LEVYW is callable by the company beyond this at $0.01/warrant.

      Hope this helps.
      Shailesh

          • says

            Hi Joe,

            Do you mean at $24/share? No you do not have to sell the common (LEVY). However, the stock might stall at that price for some time as people will be busy exercising the warrants (a little before $24/share) which will cause new stock to be issued and come to the market (dilution).

            Regards,
            Shailesh

      • confetti says

        Mr. Kumar, Could you please clarify about how the 1-cent redemption works in TACOW’s plan? If the company gives notice of redemption, will the warrants become worthless immediately? I’m hoping they won’t. The language in the prospectus sounds like warrant-holders may be given notice and a window of time in which to either exercise their warrants or sell them before they become worthless. Here is the language from page 30 of prospectus:

        “We have the ability to redeem outstanding warrants at any time after they become exercisable and prior to their expiration, at a price of $0.01 per warrant, provided that the last reported sales price of our common stock equals or exceeds $24.00 per share for any 20 trading days within a 30 trading-day period ending on the third trading day prior to proper notice of such redemption provided that on the date we give notice of redemption. … Redemption of the outstanding warrants could force you (i) to exercise your warrants and pay the exercise price therefor at a time when it may be disadvantageous for you to do so, (ii) to sell your warrants at the then-current market price when you might otherwise wish to hold your warrants or (iii) to accept the nominal redemption price which, at the time the outstanding warrants are called for redemption, is likely to be substantially less than the market value of your warrants.”

        • says

          Yes, your understanding is correct. When the notice of redemption is issued the warrants will be worthless. However, there is a 30 day period prior to this notice when the stock price needs to consistently close at $24 or above for 20 out of these 30 days. Including weekends, this implies 38-39 total calendar days. If stock price approaches $24 and appears to be heading higher (due to improved business performance), warrant holders will start redeeming their warrants. There will be tremendous liquidity for a short while and you will be able to redeem or sell your warrants. During this period of 30 trading days before the notice, the warrant price should correlate with the stock price (meaning they should be priced appropriately without discount).

  10. blue sky says

    Hello Mr. Kumar,

    Thank you for answering our questions! Here is mine:

    If Company A announces that they have accepted an offer to be acquired by (or merged into) Company B before Company A’s common stock warrants expire in 30 days, and the announcement of the buyout causes the stock price and the warrant price to increase well above the strike price, will holders of Company A warrants typically have the ability to either sell the warrants or exercise the warrants up to, and including, the date that the Company A warrants expire (since buyout deals usually take more than 30 days, after being announced, to be completed)?

    Expressed differently, does the news that Company A has agreed to be purchased by Company B (at a price higher than the current stock price for Company A) ever cause the price of Company A’s warrant to decline or become unsellable or unexercisable, given that the expiration date of Company A’s warrants will occur in 30 days, well before the completion of the buyout?

    Again, thank you very much for answering our questions and concerns.

    • says

      As long as the warrants are not expired, they will remain exercisable or sellable. Unless the acquisition/merger is at terrible terms for the Company A’s shareholders, it is unlikely that the warrant price should decline on the announcement of the buyout.

      There is an exception though that depends on the terms of the warrants. There may be a clause written into the warrant offering document that makes it redeemable by the company above a certain stock price. This maybe something like “if the price of the common stock rises above $X and stays above this level for 20 days in the previous 30 trading days, the company has the right to redeem the warrants at $0.01/warrant”. If the acquisition causes the stock price to go above $X and stay there consistently, the value of the warrant may decline and the company may choose to call it in if this clause exists.

      This is because the warrants are normally issued as a sweetener with a stock or debt issue. The idea is to entice the investors to purchase the equity by promising a leveraged return with the warrants. If the company can get its stock price above a certain level, this enticement is no longer necessary and the company would like to retire the warrants to avoid further future equity dilution.

      • blue sky says

        Thank you, Mr. Kumar, for your very fast and informative reply!

        I’ll be studying your past and future articles, and reading your questions and answers sections further, as you are clearly very knowledgeable, considerate, and helpful to your readers.

        Best regards to you!

  11. Tony says

    Dear Shailesh,

    I’ve some bonus share warrants, the exercise price is 8p and the share’s are currently trading at 28p, I’ve 400,000, but I don’t have the finance to exercise the warrant in one go, can I exercise the warrants in trenches e.g 100,000 at a time

    • says

      Hi Tony,

      I am sure you can exercise in tranches. Are these warrants listed on an exchange? If they are, you could just sell them instead of exercising so you will not need to put up any of your own capital. If not, please check with the company that issued them and they should tell you the minimum quantity, but I expect 100,000 at a time should be fine

      Regards,
      Shailesh

  12. Bob says

    I do not fully understand these stock warrants. I have 4000 shares in NAK Northern Dynasty Mineral. I just read yesterday that that as of March 4, 2015,…looking at the following article, what happens to my 4000 shsres. I purchased them at .56 cents per shsre. Thank you

    PRESS RELEASE
    Northern Dynasty Completes Prospectus to Clear Special Warrants
    By
    Published: Feb 25, 2015 5:00 p.m. ET

    SHARE

    VANCOUVER, Feb. 25, 2015 /PRNewswire/ – Northern Dynasty Minerals Ltd. (NDM)(nyse mkt:NAK) (“Northern Dynasty” or the “Company”) reports that further to the Company’s news releases of January 13, 2015 announcing the sale of 35,962,735 special warrants to raise of $15,499,939, the Company has now filed and received a receipt from certain Canadian securities regulators for the final short form prospectus qualifying the distribution of the 35,962,735 common shares (the “Common Shares”) of the Company issuable upon exercise of the special warrants. A copy of prospectus can be downloaded from http://www.sedar.com. Accordingly, these Common Shares when issued in accordance with the terms and conditions of the special warrant certificates will not be subject to resale restrictions in Canada. All special warrants, except those held by US holders and one principal shareholder will be automatically exercised at 4:00 p.m. on March 4, 2015 and such holders will automatically receive the underlying Common Shares without any further action on their part. The balance of the special warrants can be exercised over a period of up to 24 months from their issuance.

    The issuance of the Common Shares by the Company has not been registered under the United States Securities Act of 1933, as amended (the “U.S. Securities Act”) and such Common Shares will be issued pursuant to available exemptions from registration. The Company has filed a registration statement under the U.S. Securities Act to register the resale of Common Shares to be issued to certain U.S. holders of the special warrants. The registration statement was declared effected by the United States Securities and Exchange Commission on February 24, 2015. A copy of the registration statement can be downloaded from http://www.sec.gov.

    • says

      Hi Bob,

      If you only own the shares and not the warrants, there will be no change for you. You will continue to hold 4000 shares. However, since 36 million new shares are being issued and they will come into circulation on the market, that might pressure the stock price downwards.

      Regards,
      Shailesh

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