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Are warrants warranted? Or just stock options that “don’t get no respect”?

Warrants cost a lot less than the stocks they give you a right to buy—and when stock prices rise, warrant prices often rise faster. But warrants are also far riskier than stocks.

Warrants are like options. They give you the right to buy stock in the company that issues them for a set price (the exercise price) for a set time.

But unlike an option, a warrant is issued directly by a company, whereas an option is an instrument created through stock exchange activity. The stock represented by the warrant is delivered by the issuing company directly from its treasury. The stock represented by an option is delivered by an investor holding existing shares in his account.

Where warrants originate

When a stock, bond, preferred share or some other security is too speculative, too low-yielding, or unattractive for some other reason, a company will often attach a warrant to it as a little something extra to entice you to buy. Warrants are detachable after the initial sale, either immediately or after a stated length of time. Eventually you can trade them separately.

Some—but not many—high-quality stocks have warrants. Sometimes that’s because companies issued them long before they reached their lofty status. Or, they may have issued warrants as a sweetener in a merger or acquisition transaction.

But the important thing to remember is this: in most cases (though not always), warrants give you the right to buy lower-quality shares.

When stock prices climb, your broker may suggest that buying warrants is a better choice than buying stocks. That’s because warrants cost a lot less than the stocks they give you the right to buy. This leverage can give you much higher returns. Still, conservative investors are better off buying stocks rather than warrants. Though it takes less money to buy warrants, they’re much riskier than stocks.

Warrants are a so-called ‘wasting asset”. Since they have a set life, all things being equal, they decline in value a little each day. Of course, a warrant’s life may extend over several years (unlike options, which also give you the right to buy stock at a set price, but usually expire within a matter of months).

Lots of ways to lose with warrants

If you hold a warrant past its expiry date—either because you forget to exercise it, or because the price of the stock fails to go up enough to make exercising the warrant worthwhile, it becomes worthless.

If a warrant gives you the right to buy a stock that’s truly appealing, you’re not likely to get it cheap. Often warrants that seem cheap to begin with are the ones that get a whole lot cheaper.

The generally-accepted rule is that when a stock rises, its warrants are apt to rise even faster. This can be true in the short term. But in the long run, several factors can combine to make your initial choice between stocks and warrants more difficult.

Start by checking to see whether the stock is trading above or below the warrant’s exercise price. If the stock is below the exercise price, you have to figure out if it has the prospect of rising above that price—before the warrant expires.

The stock may become a better choice when the warrant’s expiry draws near. That’s especially true if the shares remain below the warrant’s exercise price. Warrants with a lot of life left in them, however, contain time value. So they never become worthless, even when the stock trades below the exercise price.

Of course, when you buy a warrant you pay a premium above its actual exercise value. The premium generally shrinks as the warrant nears the end of its life. The warrant will be a poor choice if the stock is unlikely to rise enough to offset the premium.

All things considered, warrants are apt to appeal more to speculators than to conservative investors. When you choose between stocks and warrants, keep these things in mind:

■ Consider leverage: It takes less money to buy warrants than its does to buy stocks.

■ Beware of bargains: If a warrant looks very cheap, its low price may signal danger—not a bargain.

■ Warrant prices are volatile: Since warrants are more speculative, their prices are generally subject to quicker and wider swings than stock prices.

■ Remember income: Dividends can make a big difference to your long-term investment success, especially if you re-invest them. But warrants don’t pay dividends. Regular dividends also work against the chance of the stock rising above the exercise price.

 

 

The Investment Reporter, MPL Communications Inc.
133 Richmond St. W., Toronto, On, M5H 3M8, 1-800-804-8846