Stock Warrants

Stock warrants make for an interesting alternative to common stocks.

In general, warrants offer a way to magnify the returns -- positive or negative -- for an ordinary stock, adding a form of leverage to your investment.

Many different companies, from REITs to banks, offer warrants as a way for investors to buy shares directly from the company.

Warrants vs. stock options

Warrants enable the owner to buy stock at a predetermined price some date in the future. For example, Wells Fargo (NYSE:WFC-) warrants allow investors to buy the company's stock at a price of $34.01 per share in October 2018.

Thus, anyone who owns these warrants can, at any time before October 2018, turn in their warrants, plus $34.01 in cash, and receive one share of Wells Fargo (NYSE:WFC) stock, regardless of the company's stock price at the time.

You can think of a warrant in a way similar to a stock option. Like warrants, stock options give you the right, but not the obligation, to buy shares of a company at a predetermined price. There are a few differences, however. 

  1. Warrants are generally longer term. Stock option expiration dates rarely go out further than two years. Warrants, however, can span years, and even decades. American International Group warrants issued in 2011 won't expire until 2021, a full 10-year lifespan.
  2. Shares are issued by the company. Whereas a stock option gives you the right to buy shares from the open market, warrants give you the right to buy stock from the company directly. Thus, when warrants expire in the money, the company will issue new shares to sell to you at the exercise price.
  3. Warrants have additional protection. One common feature of a warrant is an "anti-dilution provision," which reduces the exercise price for a warrant to adjust for a bigger dividend. A dividend can have a negative effect on a company's stock price. Thus, warrants, which adjust for dividends, are in some ways "safer" than stock options, which don't adjust for dividends paid by the underlying company.

How warrants work

An example may help you better understand how warrants can magnify returns on a stock. I'll use a fictional company -- Foolish Enterprises -- as an example.

Suppose Foolish Enterprises currently trades for $20 per share. The company also has warrants trading on the open market, which allow you to buy the stock for $30 per share, 10 years from today. These warrants currently trade for $2 each.

  • Current stock price: $20 per share
  • Current warrant price: $2 per warrant
  • Warrant exercise price: $30 per share

A warrant is profitable if the stock price exceeds the cost of the warrant plus the exercise price at expiration. So, in this case, a warrant would be a profitable investment if shares traded above $32 ($30 exercise price + $2 warrant price).

If, for example, Foolish Enterprises traded for $40 per share in 10 years, the warrants would be worth $10 each. The return on the warrant would be 400% -- a good return, no doubt.

However, if the stock is worth less than $20 in 10 years, the warrants will expire worthless. As such, investors would lose their entire investment. The table below shows profits or losses by buying the stock or the warrants at varying stock prices in the future.

Stock Price at Warrant Expiration

Return on the Stock

Return on the Warrant

$20

0%

(100)%

$25

25%

(100)%

$30

50%

(100)%

$32

60%

0% (breakeven)

$35

75%

150%

$40

100%

400%

As you can see, the gains and losses are magnified dramatically. Below $30 per share, the warrants result in a 100% loss of the investment. However, above $32 per share, the return on warrants quickly catches up to the return of the stock, eventually surpassing the stock's return several times over.

It's worth pointing out that it is very possible for a warrant to result in a complete loss, even if the stock price rises. In this example, the stock had risen 60% just for the warrant to reach breakeven.

Why investors use warrants

Warrants have several advantages over common stocks beyond greater gains or losses than the underlying stock.

Warrants can also be used for protection. Suppose you think a company is headed toward absolute success, or complete and total failure. Further, suppose its shares trade for $100 each, whereas warrants cost only $10 each. In this case, you can expose yourself to the upside of the stock's price without risking $100 per share. Your maximum risk is $10 per warrant, compared to $100 per share for the common stock.

Likewise, warrants can be used for a "placeholder" in your portfolio for a stock you want to wish to own, but do not have the capital to buy today. The lower price of a warrant allows you to benefit from the ups and downs of the stock, while dedicating only a small amount of capital to the investment.

Due to the outsize gains or losses warrants tend to create, it's commonly advised that they should be used carefully and sparingly. Unlike common stock, the profitability of a warrant hinges on a set timetable, adding additional risk that a company's share price won't move higher by the time the warrant expires.

Jordan Wathen has no position in any stocks mentioned. The Motley Fool recommends Wells Fargo. The Motley Fool owns shares of Wells Fargo. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.