The Difference Between an Option and a Warrant

Warrants and options, while similar, have several important differences.

Warrants and options, while similar, have several important differences.

Warrants and options share several characteristics but are fundamentally different investment instruments. Options contracts, known as calls and puts, bestow the right, but not the obligation, to buy or sell an underlying stock or other asset at a predetermined strike price on -- and for American-style options, before -- a termination, or expiry, date. Warrants provide the right to buy an underlying stock from the issuing company at a fixed exercise price until the expiry date. Differences relate to how these derivatives are issued, traded, exercised and priced.

Issuance

Warrants are commonly issued by corporations and are either attached to other instruments, such as preferred shares or bonds, or are unattached, or "naked.” The corporation collects the warrant price, or premium, at the time of sale. Options are written by traders and financial institutions on an options exchange; premiums are not collected by an issuing corporation. Corporations raise capital by issuing stock warrants but have no stake in stock options. Because corporations create new stock shares when warrants are exercised, stock warrants dilute the earnings per share of the issuing corporation, whereas options have no such effect.

Structure

Options are highly standardized exchange-traded products that have well-defined strike prices and expiry dates. Warrants are over-the-counter products, meaning they can be highly customized by the issuer. Option expiration dates can range from one month to three years. Warrants have much longer lifetimes, sometimes up to 15 years. An equity option represents 100 shares of underlying stock, but the conversion ratio for a warrant is set by the issuing corporation and can be convertible into a fractional number of shares.

Pricing

The current price of an option or warrant is composed of time value (based on the time until expiration) and intrinsic value (the difference between the strike price and the current price of the underlying stock). However, corporations always issue warrants with strike prices above current stock prices. Option writers can choose from a standard set of strike prices, including strikes below the current stock price. Option buyers thus have many premium choices depending on strike price; warrant buyers have no such flexibility.

Trading Strategies

Options can be sold long or short, but corporate-issued warrants are long only; corporations cannot issue short warrants. This difference and the flexible premium choices on options make them more suitable to certain trading strategies such as credit spreads, where options are simultaneously purchased and shorted, allowing the writer to collect the net premium. In addition, corporate-issued warrants provide no downside price protection for hedging against a declining underlying stock, but because options can be shorted, they are useful in this regard. Another kind of warrant, a “covered” warrant, is issued by third parties and operates much like an option.

Resources

  • "Share Investing For Dummies (Kindle Edition)": James Dunn
  • "Derivatives Demystified: A Step-by-Step Guide to Forwards, Futures, Swaps and Options": Andrew M. Chisholm

Photo Credits

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