When you buy a regular stock, you own a small part of a company. When you buy a warrant, you own nothing but a right. It can be compared to a coupon that allows you to buy a stock at a discounted price in the future, regardless of how much the stock price has risen on the exchange in the meantime.
"Fear and worry are just misplaced imagination."
— Florence Scovel Shinn
In the financial world, it is important to have your imagination in the right place. Warrants can provide enormous returns if you guess the correct direction of the stock price, but they can also eat up your entire investment if you are wrong.
How it works in practice
Let us say that the company Stock Inc costs 100 kroner today. You buy a Call warrant that gives you the right to buy the stock for 110 kroner in one year. This warrant might only cost 5 kroner.
- Scenario A (Success): In one year, the stock suddenly costs 150 kroner on the exchange. You can then use your warrant to buy the stock for only 110 kroner. You have made a lot of money on a small investment (this is called leverage).
- Scenario B (Failure): In one year, the stock costs 90 kroner. It makes no sense to use the right to buy it for 110 kroner. Your warrant expires worthless, and you have lost the 5 kroner you paid for it.
Time value disappears: A warrant has an expiration date. Every single day that passes without the stock moving in your favor, the warrant loses value. This is like an ice cube melting in the sun.
Pros and cons
Advantages
- Leverage: You can achieve a very high percentage return with relatively little money (huge upside).
- You know exactly what your maximum loss is (the amount you bought the warrant for).
- Can be used as insurance to protect a portfolio you already own.
Disadvantages
- Extremely high risk. It is very common for warrants to expire with zero value.
- The instrument is complicated, and the price is affected by volatility, time, and interest rates.
- Companies often issue warrants to raise money, which dilutes the ownership stake of the existing shareholders.