Stocks, debentures, bonds, mutual funds, gold, etc., are some of the well-known avenues where we invest. However, some financial instruments are not-so-commonly known and less explored. One such instrument is a share warrant.
This article covers the basic concept of share warrants, why companies issue them, how they work, types of warrants, advantages, disadvantages and tax implications.
What Are Share Warrants?
Share warrants or stock warrants are documents issued by a company that give you the right to buy or sell the company’s shares at a specific price at a particular date or within a set period. By owning share warrants you get the right to buy or sell shares of a company at a particular price, but you are not obliged to do so.
Why Do Companies Issue Warrants?
To raise capital
Issuance of warrants helps companies to benefit in two ways. One is from money received against warrants and another is from newly issued shares when these warrants are exercised. Investors may find warrants in the stock market appealing because of their cheaper costs. The more investors show interest in purchasing warrants, the more capital the company would be able to acquire.
To attract and retain employees
Companies may offer their employees equity-linked warrants with an exercise date (the day at which one can use the right to convert share warrants into actual shares) in the far future as an incentive. As they get the right to buy their ownership stake at a probably lower price in future, they may stay motivated to keep working for that company for a long time.
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How Do Stock Warrants Work?
Here are some terms that may help you better understand how warrants in the stock market work.
- Strike/exercise price – A strike price is a price fixed by the company at which you can buy or sell shares in future, irrespective of their market prices.
- Expiration date – The expiration date is the date after which you cannot exercise warrants.
- Warrant price – Warrant price is the price you are required to pay to the issuing company to purchase warrants. Generally, the warrant price is fixed at a per-share price and is typically a fraction of the stock price.
- European warrants – These are the warrants which you can exercise only on a pre-decided expiration date.
- American warrants – These are the ones you can exercise on or before a pre-decided expiration date.
Let’s understand how stock warrants work with an example. Suppose XYZ Limited issued American warrants with a strike price of ₹200 per share for the upcoming five years.
The current stock price is ₹165 per share, but you believe the stock price will jump above ₹200 per share soon. So, you buy a warrant that gives you the right to buy 100 shares of XYZ limited at ₹200 per share. The warrant price is ₹10, which brings your total spending to ₹1,000.
Scenario 1: Suppose, after four years, the stock price rose to ₹280 per share. Here, exercising the warrant could benefit you as you can buy 100 shares at ₹20,000 instead of ₹28,000.
You could instantly get a discount of ₹8,000, and after subtracting the warrant price of ₹1,000, your net gain would amount to ₹7,000. Once you exercise the warrant, the company will issue you new shares.
Scenario 2: Suppose you kept that warrant till the expiration date with the hope of a price rise. However, on the expiration date, the stock price fell to ₹160 per share. Here, exercising the warrant might not be a smart decision.
As you do not exercise the share warrant, it will lapse after expiry, and you will lose the ₹1,000 you paid as a warrant price.
You also have an option to sell equity warrants to other investors until expiry.
Types Of Stock Warrants
Those warrants which give you the right to buy a company’s shares at a particular price within a specific time are called call warrants. Exercising the call warrants would be beneficial when the company’s stock price goes above the strike price (The price at which the warrants give you the right to buy that stock)
For instance, you purchased call warrants with a strike price of ₹125. If the underlying stock’s price goes above ₹125, you can get shares at a discount if you exercise warrants. However, if the stock price is ₹125 or below, exercising the warrant would not make sense.
Those warrants which give you the right to sell a company’s shares at a particular price within a specific time are called put warrants. Companies issue put warrants to attract larger investments and reduce the risk for investors. This way, even smaller or not-so-established companies may attract investors. Exercising the put warrants would be beneficial when the company’s stock price goes below the strike price (The price at which the warrants give you the right to sell that stock).
For instance, you purchased put warrants with a strike price of ₹120. If the underlying stock’s price is below ₹120, you may get a profit if you use warrants to sell the shares. However, if the stock price is ₹120 or more, exercising the warrant may not help you gain.
Advantages And Disadvantages Of Warrants
|Potential to offer better stock prices than the market at lower costs.|
Help to hedge against the downside.
Tradable financial instrument
No dividends, no voting rights
Lead to equity dilution
Taxes On Stock Warrants
- When you exercise the warrant, the difference between the strike price and the market price of the share is considered ordinary income and attracts tax accordingly.
- When you sell these shares, the difference between the strike price and the selling price would be your capital gain and would attract tax based on the holding period of shares, i.e. long-term capital gain tax if held for over 12 months and short-term capital gain tax if held for less than 12 months.
Share warrants may offer you the benefit of getting or selling shares at a better price than the prevailing stock price in future. However, this benefit may come at the risk of losing the marginal investment you make to purchase warrants.
In both cases, companies may benefit as they can raise capital or increase their equity base by issuing equity warrants or new shares.
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The stock warrants may offer you higher potential returns. However, whether stock warrants would turn out to be a good investment will depend on the stock price movements.
You may benefit if you exercise call warrants when the company’s stock price exceeds the strike price. In the case of put warrants, you would benefit when you exercise them when the stock price drops below the strike price.
No. One of the drawbacks of warrants is that they do not pay dividends to the investors.
A primary difference between a warrant and a share is that a shareholder gets partial ownership in the company, and a warrant holder gets the right to buy or sell shares at a specific price within a set period.
One can redeem warrants on a pre-decided expiration date in case of European warrants, and on or before expiry date in case of American warrants.