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What are warrants, and how do they work?

Last updated: 27th February 2021

Even if you’ve never invested in anything except property, you’ll undoubtedly have some understanding of the stock market – and you’ll know at least a little bit about other investments like bonds and commodities.

But you’d be forgiven for never even having heard of a warrant, other than as something you’d put out for someone’s arrest. They’re an interesting investment that’s coming back into fashion though, so in this article we’ll briefly explain what they are, why people use them, and what the risks are.

What are warrants?

A warrant (more correctly, a “call warrant”) is very similar to an option: it gives you the right (but not the obligation) to buy shares in a particular company at some point in the future, at a price that’s already been agreed.

The three key ingredients in a warrant are:

  • The “strike price”, meaning the set price you can buy for in the future
  • The “conversion ratio”, meaning how many warrants you need in order to purchase one share (a 5:1 ratio would mean five warrants allow you to buy one share)
  • The expiration date, after which the warrant becomes worthless if it hasn’t been executed

Some warrants can only be executed on the expiration date itself, whereas others can be executed at any time up to and including that date – so it’s important to be clear which is the case.

Just like shares, warrants are originally issued by the company itself but can then be traded between investors.

Why are warrants used?

Warrants are generally bought by investors who want to get leveraged exposure to the underlying investment.

For example, say a share is trading for £1, so buying 100 shares would cost £100. You might decide to make that investment if you thought the price was going to go up.

Alternatively, say you could buy warrants in that same company for 10p, with a 5:1 ratio. Spending £100 on buying the warrants would give you the option to buy 200 shares at some future point – so you could get double the exposure for the same outlay. If the value of those shares go up (as long as they go above the strike price), you’d get a greater capital gain by spending the same amount of money on the warrants compared to the shares.

Sometimes you don’t have to pay anything for warrants: they’re given away by a company for free as an additional incentive to invest in their shares.

What are the disadvantages of warrants?

If warrants are given for free, there’s no disadvantage to the investor because they paid nothing so have nothing to lose: if the warrants expire below the strike price, it’s a shame but no-one has lost out.

There are, of course, still all the existing risks of holding the shares themselves. It’s possible that the price of the shares will fall over time or the company will go out of business, in which case the investor suffers as a shareholder but the warrants just become worthless.

When warrants are bought for a price, the disadvantage is the same as any type of leverage: it magnifies losses as well as gains.

If the shares fall in value (and therefore move further away from the strike price), you’d expect the price you could achieve for the warrant (by selling to another investor) to fall more rapidly than the price of the share.

Liquidity is another disadvantage: because warrants are a niche financial instrument, there will never be as liquid a market as there is for shares if you want to exit your investment. You also don’t have the ownership advantages that you’d get with shares – such as dividends and voting rights.

Who are warrants right for?

Generally speaking, warrants are suitable for sophisticated investors who are bullish on the prospects of a particular company and want to magnify their gains if their shares rise in value.

If you’re allocated warrants for free as part of an investment you would have made on its own merits anyway, then it’s a bit different: the worst-case outcome is still that they end up being worthless, but you wouldn’t be out of pocket.

Still though, warrants are a complex financial instrument and it’s worth making sure you read carefully about how the specific warrant issue works so you can come to your own view about how likely they’re likely to be in the future.

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