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, of course, let you buy stock in the company that issues them. They give you the right to buy for a set price (the exercise price) for a set time.
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).
Warrants can become worthless
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, never become worthless—even when the corresponding stock falls way 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.
Where do warrants come from?
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. It’s 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 (like those we rate ‘Very Conservative’ or ‘Conservative’) have warrants. Sometimes that’s because they issued them before they reached their current status. Or, they may have issued warrants as part of a merger or acquisition.
The important thing to remember is this: in most cases (though not always), warrants give you the right to buy lower-quality shares.
This is an edited version of an article that was originally published for subscribers in the January 7, 2022, issue of The Investment Reporter. You can profit from the award-winning advice subscribers receive regularly in The Investment Reporter.
The Investment Reporter, MPL Communications Inc.
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