Warrants - The Basics
Issuance
A warrant is often issued to institutional investors as a sweetener during a fund raising exercise. If an investor purchases a block of new stock or participates in a bond sale, they may be entitled to receive a pre-arranged amount of warrants. In this way, warrants have a similar purpose to CVR‘s that are offered to target shareholders during mergers and acquisitions.
Performance
By owning a warrant, the positive delta means the holder will have greater long position than had they just held a stock position. In addition, the positive gamma of the warrant means the holder will become even “longer” as the underlying stock moves up. Likewise, the holder becomes “shorter” as the stock moves down. Hence their similarities to the trading of put and call options.
Trading Warrants
Therefore, by selling part of their stock holding, (or by shorting stock if this holding is already at or below zero) as the stock rises, the investor can maintain their original position. Then, when the stock moves lower, the investor will need to buy stock as their position becomes “shorter”. As the stock moves back and forth around the exercise price the investor will make money “scalping” on the buying low and selling higher activity.
As warrants are so long dated it is possible the stock rises so far above (or below) the exercise price that the gamma becomes ineffective. In other words, changes in the warrant value would be in lock-step with the stock, or if the stock is so far below the exercise price that the value of the warrant will barely change. Therefore, it is in the interests of the investors to see the stock remain at or near the exercise price level to benefit from the largest amount of gamma and maximize the buying and selling (scalping) quantities, thus greatly increasing profit.
Comparisons
- The issuance of a warrant is similar to the call option in a convertible bond. The process of convertible bond arbitrage has many similarities to a warrant trading strategy
- Warrants are issued on the primary market and can be traded on a stock exchange. Initially they are a contract between the company and the buyer
- Unlisted Warrants are considered over the counter instruments
- A Warrant issued by the company itself is dilutive and as such MUST be considered when calculating the earnings per share or Price Earnings Ratio or other such metric.
- Warrants are not standardized like exchange-listed options
