Major Differences Between Warrants and Options: Know the Risks vs. Rewards
Although options and warrants might seem similar to each other, they have some important differences. Investors should understand the risks versus the rewards.
In this article, we will discuss what is an option, what is a warrant, what their differences and similarities are, and what the pros and cons of each are.
Investors should understand these differences thoroughly before deciding whether to invest in options or warrants.
What is a Stock Option?
Options are a derivative product that gives the holder the right to buy or sell an underlying asset at a predetermined price. The underlying asset is, most commonly, stock in a public company, but can also be any other asset class such as ETFs, commodities, bonds, etc.
A call option is an option to buy an underlying asset and a put option is an option to sell an underlying asset.
Options are most commonly sold on the secondary market, i.e., the “stock market,” although there is a class of options called “exotic options” that can be sold “over the counter” (OTC). OTC sales refer to sales that are done from a company directly to a client, instead of via a public market.
Exotic options are out of the scope of this article as they differ in several ways from the more commonly known options contracts.
An option can be exercised any time at or before its expiration, which is always short-term. Options can contain expiry dates of anything from a few weeks to one to two years, although the majority expire in a month.
We have previously written an in-depth article on what options are and how they work, and recommend reading it to get a complete background on this investment product.
What is a Stock Warrant?
A warrant is also a derivative product that gives the holder the right, but not the obligation, to buy or sell an underlying asset at a predetermined price. The asset is almost always stock of a company.
Warrants differ from options in the following ways:
- Warrants are sold over the counter (OTC), meaning that investors buy them directly from a company and not from a stock exchange. (There is a type of warrant called a “covered warrant” or a “naked warrant” that is sold on the secondary market, but this is a specialized instrument that is much more like an option rather than a warrant, so we will not be covering it.)
- Warrants tend to be cheaper than options, giving them much higher leveraging and gearing—a fancy way of saying that you get “more value for your buck” if share prices go up, but you also have more risk if they go down.
- Warrants can have expiration dates of up to fifteen years, unlike options that rarely surpass three years. This makes warrants more suitable for long-term investors.
- European warrants can only be exercised at the date of expiration, never before. This greatly increases their risk.
Like options, a warrant to buy is a call warrant and to sell is a put warrant.
Although warrants tend to be cheaper than options, they still include a premium to be paid.
Because warrants are not issued on an exchange, they have less standardized features. For example, options for share equity typically have set expiration terms and a fixed number of options per contract—100 shares. This is much more varied with warrants.
The most common duration for warrants is usually a year or two although, as mentioned above, they can have expiry dates of a decade or longer.
What to Watch out for When Buying Warrants?
Because warrants are not standardized like options are, it is vital to see what you actually have the right to buy. With options, you typically get the right to buy 100 underlying shares. With warrants, you might get as little as one or even none—sometimes companies require you to have several warrants to get one share.
For warrants with extremely long expiration dates, the risk is particularly high and this should be taken into account by investors with a low risk tolerance.
Like options, buying a warrant confers no voting rights at all in the company, even though your potential earnings will be affected by the votes of shareholders.
One thing warrant holders must be particularly alert to is Redemption Announcements. These are often included in the warrant contract and give the issuing company the right to redeem warrants under certain conditions. If warrant holders don’t act on the announcement, their warrants might end up losing all their value.
It is vital to study the prospectus to know about the issuing company’s policy regarding redemption announcements, and also to keep one’s ear to the ground for any announcements.
Once a redemption is announced, investors usually have no more than 30 or 45 days to redeem the warrants.
Brokerage firms don’t always alert you to upcoming redemptions.
Places to listen out for redemption announcements include:
- Your brokerage firm
- The issuer’s website
- The SEC’s EDGAR database—the Electronic Data Gathering, Analysis and Retrieval tool which lists corporate filings
- Financial news sites
- Social media
- The Dividends / Distributions / Splits section of the FINRA’s “Over the Counter Equities” page