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Ask TheStreet: All About Warrants

Gregg Greenberg

Editor's Note: Ask TheStreet is designed to answer questions about the market, terms, strategies and investment methods. Please email us to ask a question, but keep in mind that we cannot offer specific investment or stock-related advice.

I often read about companies issuing warrants. What are they, and how do they affect a stock's price? Thanks, L.D.

Just to make it clear from the outset, warrants in the stock world bear no relation to those issued by high-plains sheriffs and hanging judges. So there is no need to worry about an outlaw CEO in our midst.

Put simply, a warrant is much like an option, in that it offers the holder the right, yet not the obligation, to purchase a set quantity of the underlying security at a certain price and time in the future.

The big difference between a warrant and an option is that warrants are issued by companies, whereas options are agreements between two third parties, neither of which are necessarily connected to the company.

In other words, if a warrant is exercised, then the issuing company is responsible for delivering the required shares of stock (or a commodity, index or currency). In an option transaction, it is the responsibility of the option holder to deliver the shares.

Warrants are certificates that are more often than not issued along with a bond or share of preferred stock. They generally trade independently of the security with which they are issued, meaning you can buy and sell them like stock.

Companies usually issue call warrants with a strike price much higher than the current market price. The length of the issue can be anywhere from a year to forever and is spelled out on the certificate. If a warrant goes unused over the span of its existence, then it expires worthless.

Like a call option, if the market price of the underlying security rises above the warrant's exercise, or strike, price, then the holder can purchase the security at the exercise price and resell it for a profit.

The downside of a call warrant occurs if the underlying share price falls. If the stock's price never exceeds the warrant's strike price over the duration of the warrant, then you never have the opportunity to exercise it and will therefore lose your entire investment. The maximum possible loss is the price of the warrant.

Put warrants are not as prevalent, but they do pop up from time to time. A put warrant gives the holder the right to sell the underlying share for an agreed price, on or before a specified date.

Speculators are often attracted to warrants, as they are usually low in price and highly leveraged. In other words, a warrant costs less than the underlying, moves up more when the underlying's price rises and moves down more when it falls. They don't offer the holder any dividends or voting rights, but those rarely matter to short-term speculators anyway.

Warrants tend to be the domain of lower-quality or struggling companies. Some companies also include warrants as part of a new issue in order to drum up interest in a new security.