How to Make Passive Income with Warrants
Updated: Mar 10, 2021
First created in the 1920s, a warrant is similar to an option, except for the fact that it's issued directly by the company, while an option is offered by the central exchange. A warrant is designed to give the holder the right to buy a stock at a set price and at a set quantity- on or before a future date. Warrants are typically issued by companies to raise capital and are often traded on the open market like stocks. Nowadays, many warrants are issued on the shares of natural resource companies that are involved in the extraction and processing of gold, silver, oil, natural gas, copper and more.
Call Warrants and Put Warrants
Once again, warrants resemble options in that there are two kinds. One is a call warrant, while the other is a put warrant. A call warrant represents a specific amount of shares that can be bought from the seller at a specific price, on or before the expiration date (the last day a warrant can be executed). A put warrant is on the other end of that spectrum. It represents a specific amount of shares that can be sold back to the seller at a specific price, on or before the expiration date. The payment of the strike price results in a transfer of the specific amount of shares of the underlying asset.
In addition, a warrant doesn't have to only represent shares of a company. It can also represent currencies, indexes or even commodities.
American Vs European Warrants
Warrants can be executed differently based on which country they are executed. In America, a warrant can be exercised anytime before or on the agreed expiration date, just like an American option. However, in Europe, warrants can only be exercised on the expiration date, just like an European option.
Investing in Warrants
Warrants are an exciting investment tool that many investors don't know about. They can be a high risk vehicle that offer exceptional high rewards as well. They are often used by speculators and hedgers protecting their bets on an asset they've invested through some other form. For instance, maybe you bought $5000 worth of stock shares in mega gas company, Exxon. Your only concern is that gas prices may fall in the near term. To hedge against losses in your Exxon holdings, you decide to buy a put warrant in gas expiring in 2 months. This way, if gas prices do fall, you can exercise your warrant and collect profit. You can then reinvest your earnings back into your portfolio.
Advantages of Warrants
Warrants are a great option for investors because the initial investment and the cost of ownership are comparatively low. Even better, warrants allow investors to leverage that initial cost to own a much bigger piece of the pie. For instance, going back to that Exxon example. If you wanted to buy 100 shares of Exxon at $80 per share, you'd need $8000. However, if you bought a call warrant on Exxon at $40 (priced per share), that same $8000 could potentially get you 200 shares.
With warrant costs being so low, the potential for bigger capital gains due to leverage are enormous. Because of these comparatively low costs, warrant gains can clearly outsize share gains. Investors like Warren Buffet use this tool all the time to acquire large amounts of stock.
Disadvantages of Warrants
On the other side of that token, the leverage of warrants means there's also a lot of downward risk. If the underlying asset is volatile and falls in price before the expiration date, the investor could lose a lot of money. Going back to our example earlier, if Exxon's share price fell, the percentage loss for the share price would be half that of the warrant price. In fact, the value of the warrant could fall to zero. This is all due to leverage.
In addition, a warrant holder has nearly no power with the company the warrant was issued from. Since a warrant is not actually shares of a company, that'd also mean you'd possess no power to vote, nor be able to collect dividends.
If you've learned nothing from this post, just remember warrants are just like options. Warrants are just issued directly from the company, while options are issued by central exchanges. But like any investment mentioned on this blog, it requires a lot of due diligence. Without it, you're just gambling. With it, your knowledge can be leveraged into consistent winnings that can lead to sizable gains.
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