Every stock market enthusiast would know about options in the financial market. Though complex, it is one of the most exciting instruments, as it provides good returns if traded with appropriate strategies.
Strategising trades by choosing the one with a suitable strike price, expiration, etc., is the key to a successful options trade. To do so, understanding the different instruments available in the options market is essential for investors. In today’s topic, we will discuss warrants and call options – two popular instruments in the derivative market.
Derivatives and options
Before diving into warrants, let’s brush up on our knowledge of derivatives and options.
Derivatives are contracts whose values fluctuate based on the underlying security, like stocks, bonds, etc.
Options are a form of derivative where the buyer of the options contract is entitled to purchase the underlying on a future date at a preset price. However, if the pre-agreed price is unfavourable, the buyer can cancel the contract. The speciality of options is its feature to give the purchasing right without obligations.
Warrants
They are derivative contracts that work similarly to options. These instruments authorise the investor to purchase the stock before the expiry date, at a strike price that has been agreed upon earlier.
The uniqueness of warrants is that these contracts are entered directly with the issuing company and are traded over the counter.
Pros of warrants:
- Warrants allow investors to enter large contracts with a small amount of capital. Since the asset needs to be acquired only before the expiry date, investors have sufficient time to arrange for funds.
- Choosing the right strike price allows investors to make high profits when the market price of the underlier fluctuates as expected.
- Since trades buy warrants over the counter, they are more flexible as compared to contracts on the exchange.
Cons of warrants:
- If the underying’s price does not increase beyond the warrant’s strike price, the warrant loses its value.
- Warrants may not have voting rights and dividend payments like common stocks.
- Warrants are complex instruments with various terms and conditions, which may not be easy to understand, especially for novice investors.
Call options
Call options are option contracts which give the option holder the right to buy the asset on a future date at a pre-determined price.
Well, that is how we defined warrants, too, so how are they different?
The primary difference between warrants and calls is the issuer. Stock exchanges issue call options and such contracts are more standardised.
Besides the issuing exchange, call options involve two parties – the holder (the buyer of the options) and the writer (the seller of the options). When the underlying asset’s market price goes above the strike price, the holder exercises the option to buy the security at the price agreed in the options contract. The writer must sell the asset at the agreed price, for which the holder pays the writer an additional premium.
Like warrants, call options also do not give holders the right to vote or earn dividends.
Warrants vs options
While warrants and calls are similar in their fundamental nature, some of their features are different.
Differences between warrants and options:
- Warrants are traded in the OTC market, while options are traded on stock exchanges.
- Stock exchanges list option contracts, while warrants are direct contracts with the issuing company.
- Since call options are traded on the exchange, they have higher liquidity. Warrants offer relatively lower liquidity.
- Exercising a warrant may require companies to issue new stocks, leading to the dilution of more ownership. Call options do not issue new stocks. So, they keep the existing shareholding pattern intact.
- Some warrants may have the option to get converted to common stocks, after which they may be eligible for dividends and voting rights, while call options do not have this feature.
- Call options have a shorter maturity period as compared to warrants.
Bottomline
Trading through the complexities of the financial market requires immense knowledge of all the available instruments. While some instruments may seem similar, some of their features may differ significantly, leading to a different outcome altogether.
Two such instruments are warrants and options. While both of them allow traders to hedge their risks, they are issued by different entities and have varying elements. Hence, understanding the differences between warrants and calls before investing in them is crucial for derivative traders.
FAQs
Issuing warrants allows companies to raise capital. They raise a small portion while warrants are issued, and again raise a significant portion of capital if warrants are exercised.
Besides the complexity, lack of dividend and voting rights, call options can lead to loss of premiums. When the asset’s market price does not go above the strike price, the call option expires worthless, leading to a loss of premium.
A put option is a contract that gives the option holder the right to sell the asset at a predetermined price on a future date, without any obligation to do so.
No, option holders do not get dividend or voting rights, unless they exercise their right and purchase the underlying stock.
When warrants are exercised, companies create new shares, leading to a dilution in the percentage of shareholding of existing shareholders. Hence, warrants are considered dilutive.