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Warrants Vs Options - What's The Difference?

Stephen Edge
 


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The simple answer is that warrants are issued by companies to raise money options are not. Let's take a look at how options and warrants are alike:

1) Options and warrants expire at a pre-determined date

2) Options and warrants are based on an underlying asset such as stocks

3) The seller of an option or warrant is OBLIGATED to honor the terms of the option or warrant

4) The buyer of an option or warrant must pay a price (or premium) up front

5) Options and warrants can only be exercised at a pre-determined price or strike price

6) Options and warrants can be exercised anytime (American style) or at expiration (European style). This depends on the terms of the option of course.

7) When the underlying asset of the options and warrants are trading below the strike price of the option or warrant then the price of the option or warrant is generally based on time or volatility. To grasp the time concept think of an airline selling seats on a plane that leaves in 1 day and another seat on a plane that leave in 1 month. You are more likely to get a passenger for the 1 month ticket than the 1 day ticket and, of course, the airline charges more for the 1 month ticket.

8) When options and warrants are exercised your profit is the difference between the strike price and the market price. Obviously you won't exercise you warrant or option if the price you can exercise them at is above the market price. For example, I say you can buy 1 apple from me in 2 weeks at $2. After 2 weeks the price of apples is $1. You wouldn't pay $2 for my apple now would you? Conversely if apples were selling for $3 you would gladly buy mine at $2 and turn around and sell it at $3 for a $1 profit.

Now lets take a look at the differences between options and warrants. As I said earlier companies issue warrants to raise money but do not issue options (Don't be confused with employee stock options). Why do companies issue warrants? They want to raise money. Consider the ways in which a firm can raise money. Borrow from the bank. Always short term (1 year or less) and banks have the first claim on assets of a bankrupt firm.

They can issue a bond. Companies must make semi-annual or annual interest payments on the bond and must buy back the bond when it matures. Bonds can be both long and short term. This can be a substantial drain on the firms cash.

Firms can also issue stock into the market called a secondary offering or private placement. Here the company literally sells stock in the market to an individual or small group of investors. This is to ensure that they won't sell the stock as soon as they get it. Keep in mind these additional shares will dilute earnings for existing shareholders and will also reduce their ownership stake in the company.

Another way a company can raise money is to issue warrants. These allow the company to generate money by selling stocks to the owner of a warrant who exercises the warrant. Keeping in mind the apple analogy that they will only exercise if the stock price is higher than the exercise price. Also the warrant issuer will set terms of the warrant such as how many warrants need be exercised for 1 share of stock, or that the company may buy the warrant back at their leisure if the underlying share prices trades at or above a certain price. The conditions set on a warrant are up to the issuer and vary greatly. These are called the tenants of the warrant. Conversely, with options specific conditions are already predetermined for each and every option such as expiration date - the all expire on the same day. Strike price or exercise price ladders are always known. For example, October apple options will have a strike price of $1, $2 or $3 and so will November, December and every month going forward. The strike price of the Warrant can be anything the issuer wants. If you want to buy the companies warrant these are the terms.

There is another kind of warrant called a covered warrant that are generally issued by investment banks and are very popular in Hong Kong among others. These investment banks are not looking to raise capital but to offer an additional tool for investors to manage their portfolio. There are 2 kinds of covered warrants; call warrants and put warrants. You may be thinking that calls and puts are options well they are but in the case off these warrant types it is indicating whether you have the right to buy or sell the warrants much like the option type. Covered call warrants allow you to buy or “Call Away" the underlying and covered put warrants allow you to sell or “Put to" the seller the underlying. These products are a hybrid of both the company warrant above and an option.

By: Stephen Edge

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