How to Invest in Stock Warrants

by Carmelo Montalbano ; Updated July 27, 2017
Buy strength and sell weakness

Warrants are issued by companies in order to raise money with the possibility of converting the warrants to stock and thus raising additional money in the future. Warrants are similar to stock options except that the proceeds of the warrant issuance is retained by the company. Warrant issuance may extend for as long as 15 years.

Step 1

Understand the implications of leverage in warrants. With successful credit and market timing, returns can easily exceed returns for stocks. Use a spreadsheet program and in column one, insert the issue price of the warrant. In column two, enter the maturity date of the warrant. In column three, enter the current date. In column four, enter the exercise price of the warrant. Subtract column three from column four and compute the time to expiration. Assume that the warrant is below excise price and prorate the price of the warrant over time. This is the rate of decay of the warrant.

Step 2

Recompute the time decay if the stock is trading above the exercise price. Subtract the difference between current price and exercise price. Subtract the remainder from the warrant price. The remainder is called the premium. Prorate the premium of the warrant over time remaining to calculate decay. Understand that this loss continues as expiration approaches. A rise in the price of the warrant is necessary to offset this guaranteed loss.

Step 3

Understand that at maturity, if the stock price is not above the warrant excise price, the warrant expires worthless. Understand that warrants gain in value dollar for dollar above the exercise price. Thus, for experienced investors, warrants can create exceptional investment opportunities.

Step 4

Know the conversion terms of the warrant. One warrant may represent more or less than one share of stock. Probably the best market maker for buying or selling warrants is the investment bank that represented the issuer. Warrants trade irregularly. Thus, technical trading is not useful. Use fundamental analysis for warrant trading. Know that when warrants are redeemed, the capital structure of the firm is improved, but earnings per share decline.

Step 5

Invest in warrants only after careful credit study. Warrants are often issued when companies come out of bankruptcy as 'sweeteners' to interest investors in the bankrupted companies' bonds. Detach warrants from such an offer and trade the warrants or the bonds to your advantage.

Step 6

Invest in warrants as a low-cost alternative to buying stock. Warrants have limited downside, but, like options, they do decay over time. Traders buy warrants when they like the underlying opportunity, but are uncertain about near-term market conditions. Warrants are volatile and should be used for investment and not trading purposes. Warrants cannot be used as a proxy for stock as the underlying security in option trading, further limiting their value as a trading vehicle.

Tips

  • Understand the conversion rate or how many shares of stock each warrant represents. Terms of conversion vary in each issue.

Warnings

  • Never trade warrants without understanding the underlying credit and the terms of conversion. Warrants are less liquid than stocks and trade less frequently.

About the Author

After an 18-year career on Wall Street as a trader of municipal and mortgage backed securities, Carmelo Montalbano developed a very large desktop trading application that managed more than 30 institutional portfolios. Technology and small business acquisitions continue to be his primary interest.

Photo Credits

  • http://www.sxc.hu/photo/182457