Understanding Warrants and Call Options

Warrants and call options are both types of securities contracts. A warrant gives the holder the right, but not the obligation, to buy common shares of stock directly from the company at a fixed price for a pre-defined time period. Similarly, a call option (or “call”) also gives the holder the right, without the obligation, to buy a common share at a set price for a defined time period. So what are the differences between these two?

Warrants and Call Options Similarities

The basic attributes of a warrant and call are the same:

• Strike price or exercise price – The guaranteed price at which the warrant or option buyer has the right to buy the underlying asset from the seller (technically, the writer of the call). “Exercise price” is the preferred term with reference to warrants.
• Maturity or expiration date – The finite time period during which the warrant or option can be exercised.
• Option price or premium – The price at which the warrant or option trades in the market.

For example, consider a warrant with an exercise price of $5 on a stock that currently trades at $4. The warrant expires in one year and is currently priced at 50 cents. If the underlying stock trades above $5 at any time within the one-year expiration period, the warrant’s price will rise accordingly. Assume that just before the one-year expiration of the warrant, the underlying stock trades at $7. The warrant would then be worth at least $2 (i.e. the difference between the stock price and the warrant’s exercise price). If the underlying stock instead trades at or below $5 just before the warrant expires, the warrant will have very little value.

A call option trades in a very similar manner. A call option with a strike price of $12.50 on a stock that trades at $12 and expires in one month will see its price fluctuate in line with the underlying stock. If the stock trades at $13.50 just before option expiry, the call will be worth at least $1. Conversely, if the stock trades at or below $12.50 on the call’s expiry date, the option will expire worthlessly.

The Difference in Warrants and Calls

Three major differences between warrants and call options are:

• Issuer: Warrants are issued by a specific company, while exchange-traded options are issued by an exchange such as the Chicago Board Options Exchange in the U.S. or the Montreal Exchange in Canada. As a result, warrants have few standardized features, while exchange-traded options are more standardized in certain aspects, such as expiration periods and the number of shares per option contract (typically 100).
• Maturity: Warrants usually have longer maturity periods than options. While warrants generally expire in one to two years, they can sometimes have maturities well in excess of five years. In contrast, call options have maturities ranging from a few weeks or months to about a year or two; the majority expire within a month. Longer-dated options are likely to be quite illiquid.
• Dilution: Warrants cause dilution because a company is obligated to issue new stock when a warrant is exercised. Exercising a call option does not involve issuing new stock since a call option is a derivative instrument on an existing common share of the company.

Why Issue Warrants and Calls?

Warrants are typically included as a “sweetener” for an equity or debt issue. Investors like warrants because they enable additional participation in the company’s growth. Companies include warrants in equity or debt issues because they can bring down the cost of financing and provide assurance of additional capital if the stock does well. Investors are more inclined to opt for a slightly lower interest rate on a bond financing if a warrant is attached, as compared with a straightforward bond financing.

Warrants are very popular in certain markets such as Canada and Hong Kong. In Canada, for instance, it is common practice for junior resource companies that are raising funds for exploration to do so through the sale of units. Each such unit generally comprises one common stock bundled together with one-half of a warrant, which means that two warrants are required to buy one additional common share. (Note that multiple warrants are often needed to acquire a stock at the exercise price.) These companies also offer “broker warrants” to their underwriters, in addition to cash commissions, as part of the compensation structure.

Option exchanges issue exchange-traded options on stocks that fulfill certain criteria, such as share price, number of shares outstanding, average daily volume and share distribution. Exchanges issue options on such “optionable” stocks to facilitate hedging and speculation by investors and traders.

Intrinsic and Time Value

While the same variables affect the value of a warrant and a call option, a couple of extra quirks affect warrant pricing. But first, let’s understand the two basic components of value for a warrant and a call—intrinsic value and time value.

Intrinsic value for a warrant or call is the difference between the price of the underlying stock and the exercise or strike price. The intrinsic value can be zero, but it can never be negative. For example, if a stock trades at $10 and the strike price of a call on it is $8, the intrinsic value of the call is $2. If the stock is trading at $7, the intrinsic value of this call is zero. As long as the call option's strike price is lower than the market price of the underlying security, the call is considered being "in-the-money."

Time value is the difference between the price of the call or warrant and its intrinsic value. Extending the above example of a stock trading at $10, if the price of an $8 call on it is $2.50, its intrinsic value is $2 and its time value is 50 cents. The value of an option with zero intrinsic value is made up entirely of time value. Time value represents the possibility of the stock trading above the strike price by option expiry.

Factor Influencing Valuation

Factors that influence the value of a call or warrant are:

• Underlying stock price – The higher the stock price, the higher the price or value of the call or warrant. Call options require a higher premium when their strike price is closer to the underlying security's current trading price because they're more likely to be exercised.
• Strike price or exercise price – The lower the strike or exercise price, the higher the value of the call or warrant. Why? Because any rational investor would pay more for the right to buy an asset at a lower price than a higher price.
• Time to expiry – The longer the time to expiry, the pricier the call or warrant. For example, a call option with a strike price of $105 may have an expiration date of March 30, while another with the same strike price may have an expiration date of April 10; investors pay a higher premium on call option investments that have a greater number of days until the expiry date because there's a greater chance the underlying stock will hit or exceed the strike price.
• Implied volatility – The higher the implied volatility, the more expensive the call or warrant. This is because a call has a greater probability of being profitable if the underlying stock is more volatile than if it exhibits very little volatility. For instance, if the stock of company ABC frequently moves a few dollars throughout each trading day, the call option costs more as it is expected the option will be exercised.
• Risk-free interest rate – The higher the interest rate, the more expensive the warrant or call.

Pricing Call Options and Warrants

There are a number of complex formula models that analysts can use to determine the price of call options, but each strategy is built on the foundation of supply and demand. Within each model, however, pricing experts assign value to call options based on three main factors: the delta between the underlying stock price and the strike price of the call option, the time until the call option expires, and the assumed level of volatility in the price of the underlying security. Each of these aspects related to the underlying security and the option affects how much an investor pays as a premium to the seller of the call option.

The Black-Scholes model is the most commonly used one for pricing options, while a modified version of the model is used for pricing warrants. The values of the above variables are plugged into an options calculator, which then provides the option price. Since the other variables are more or less fixed, the implied volatility estimate becomes the most important variable in pricing an option.

Warrant pricing is slightly different because it has to take into account the dilution aspect mentioned earlier, as well as its “gearing". Gearing is the ratio of the stock price to the warrant price and represents the leverage that the warrant offers. The warrant's value is directly proportional to its gearing.

The dilution feature makes a warrant slightly cheaper than an identical call option, by a factor of (n / n+w), where n is the number of shares outstanding, and w represents the number of warrants. Consider a stock with 1 million shares and 100,000 warrants outstanding. If a call on this stock is trading at $1, a similar warrant (with the same expiration and strike price) on it would be priced at about 91 cents.

Profiting From Calls and Warrants

The biggest benefit to retail investors of using warrants and calls is that they offer unlimited profit potential while restricting the possible loss to the amount invested. A buyer of a call option or warrant can only lose their premium, the price they paid for the contract. The other major advantage is their leverage: Buyers are locking in a price, but only paying a percentage up front; the rest is paid when they exercise the option or warrant (presumably with money left over).

Basically, you use these instruments to bet whether the price of an asset will increase—a tactic known as the long call strategy in the options world.

For example, say shares of company ABC are trading at $20 and you think the stock price will increase within the next month: Corporate earnings will be reported in three weeks, and you have a hunch they're going to be good, bumping up the current earning per share (EPS).

So, to speculate on that hunch, you purchase one call option contract for 100 shares with a strike price of $20, expiring in one month for $0.50 per option, or $50 per contract. This will give you the right to purchase shares for $20 on or before the expiration date. Now, 21 days later, it turns out you guessed correctly: ABC reports strong earnings and raised its revenue estimates and earnings guidance for the next year, pushing the stock price to $30.

The morning after the report, you exercise your right to buy 100 shares of company stock at $20 and immediately sell them for $30. This nets you $10 per share or $1,000 for one contract. Since the cost was $50 for the call option contract, your net profit is $950.

Buying Calls vs. Buying Stock

Consider an investor who has a high tolerance for risk and $2,000 to invest. This investor has a choice between investing in a stock trading at $4 or investing in a warrant on the same stock with a strike price of $5. The warrant expires in one year and is currently priced at 50 cents. The investor is very bullish on the stock, and for maximum leverage decides to invest solely in the warrants. Therefore, they buy 4,000 warrants on the stock.

If the stock appreciates to $7 after about a year (i.e. just before the warrants expire), the warrants would be worth $2 each. The warrants would be altogether worth about $8,000, representing a $6,000 gain or 300% on the original investment. If the investor had chosen to invest in the stock instead, their return would only have been $1,500 or 75% on the original investment.

Of course, if the stock had closed at $4.50 just before the warrants expired, the investor would have lost 100% of her $2,000 initial investment in the warrants, as opposed to a 12.5% gain if they had invested in the stock instead.

Other drawbacks to these instruments: Unlike the underlying stock, they have a finite life and are ineligible for dividend payments.

The Bottom Line

While warrants and calls offer significant benefits to investors, as derivative instruments they are not without their risks. Investors should, therefore, understand these versatile instruments thoroughly before venturing to use them in their portfolios.