What Are the Differences between Warrants and Call options?
Before learning about warrants and calls, let us talk about derivatives. These are contracts which derive their value from an underlying asset, such as commodities, securities, bullion, and indices. Prominent derivatives traded in the stock markets are futures and options. There are mainly two types of options, call and put options.
Besides these exchange-traded derivatives (ETDs), there are other types of derivatives in the market. One of them is called a warrant. Unlike call options, which are traded on stock exchanges, warrants are traded over the counter (OTC).
Warrants and call options have several similarities, with similar basic features like strike prices, expiration dates and premiums. However, there are not the same financial instruments.
Let us learn about these derivatives in more detail.
What Are Warrants?
Warrants are derivatives that give their holders the right to buy or sell a security, mostly stocks, at a certain price before the date of expiry. However, a holder can choose not to exercise their right to purchase its underlying stock. Unlike options, warrants are issued to investors directly by publicly-owned companies.
The exercise price or strike price is the price at which the underlying security can be either bought or sold. You have to pay a minimal amount to buy a warrant. This is good for both buyers and the company whose warrants are being purchased.
There are mainly two types of warrants, call warrants and put warrants. Call warrants give you the right to buy a security while put warrants provide you with the right of selling a security.
As the holder is paying a fraction of the total amount, they get to decide whether they would like to convert the warrants into shares or not, based on their analysis of the company’s fundamentals. It also gives the company an opportunity to sell more shares which will enable them to issue more equity shares for raising funds.
What Are Call Options?
A call option is a contract between two parties which gives a buyer the right to buy an underlying asset, such as stocks, commodities, currencies and bonds. Here, the option holder is called an investor or trader and the seller is called the “writer”.
In options contracts, a buyer has to pay an upfront premium. However, call buyers do not get any voting rights in that company nor are they eligible to earn any dividends.
If a call options buyer chooses to exercise the contract, the seller has an obligation to sell its underlying asset at the strike price. In contrast, if a call options buyer chooses to let their contract expire, the seller will pocket the premium.
There can be two types of settlements. In cash-based settlements, wherein no underlying assets are physically settled. It can also be a delivery settlement, wherein the options are exercised and result in physical delivery in exchange for cash and conversion of the options into shares.
Differences between Warrants and Call Options
There are several major differences between warrants and call options. Some of the significant differences are enlisted below:
- Call options are standardised contracts. In contrast, warrants are non-standardised contracts sold over the counter.
- Call options are issued by stock exchanges. However, warrants are issued directly by a company.
- Call options are publicly traded, have high liquidity and low risks of defaults. On the other hand, warrants are usually narrowly traded and have limited liquidity.
- With call options, short selling is allowed with certain guidelines, something which is not allowed in warrants.
- Call option holders get no voting rights or shareholders’ rights in that company. However, there are some types of warrants that give the holders shareholder rights after conversion to equity.
- Stock exchanges set the terms and conditions for call options. For warrants, the issuing company decides the terms and conditions for purchase.
- With call options, underlying assets are generally bonds, equities, commodities or indices. In the case of warrants, underlying assets are usually stocks and currencies.
- Call options are short-dated and rarely stretch beyond one year. Warrants, on the other, are long-dated financial instruments. The life span of warrants can stretch up to 15 years.
- Option trading works on future market principles. On the other hand, warrants follow the principles of the cash markets.
Advantages and Disadvantages of Warrants
Warrants provide some significant advantages for investors. Some of them are:
- The prices of warrants are quite low, and they offer a high degree of leverage. Due to this, warrants have a higher potential for making high capital gains.
- Warrants can make significant gains during a bullish market.
- These derivatives also reduce the risks.
- Warrants allow small-scale investors to diversify their portfolios without having to compete with institutional investors.
However, warrants also have their disadvantages. Some of the cons associated with investing in warrants are given below:
- The value of the certificate can drop to zero. If that happens before the exercise date, its redemption value is lost.
- Warrants tend to be highly volatile which poses a very risk to investors.
- These are also quite complex derivatives, due to their price adjustments.
- Warrants are not created equal, which makes it even more confusing and difficult for an average investor.
Advantages and Disadvantages of Options
Investing in options has several advantages over investing in warrants. Some of them are given here:
- One major advantage of investing in options is that one can create spreads by purchasing or selling options contracts.
- The number of trading strategies is significantly more in options than that are available for warrants.
- It is way easier to buy and sell options because they are traded on exchanges. However, warrants are only sold over the counter.
- Options are more versatile than warrants.
Investing in options also carries some disadvantages. These are:
- You must have a good understanding of the options market and the key concepts associated with it before investing.
- Options are short-dated investments which generally run for a few months. The short time span gives less time for recovering investments. Thus, along with having the potential to give you high returns, it might also lead to high losses.
- Since options are derivatives whose value is based on underlying assets like stocks and indices, even a small movement in their prices can lead to massive price differences.
- In unfavourable market conditions, you might end up losing all your available capital by paying premiums.
If you are thinking about which one to invest in, unfortunately, there is no definitive answer to this question.
Call options are better for simple and easy investments as they are quite easy to trade and available in the stock market. They are good options for beginners to invest in. On the other hand, warrants are highly transparent. They are a high-risk and high-returns instrument more suitable for medium to long term investments.
Frequently Asked Questions
What are the different types of warrants?
There are basically 2 different types of warrants. One is a call warrant, which gives the holder the right but not the obligation to purchase the underlying asset at a specific price on or before a certain date. The other is a put warrant which gives the holder the right to sell a certain quantity of an underlying asset at a specified price on or before a specific date.
What is the difference between a call option and a put option?
A call option gives the buyer the right but not the obligation to buy an underlying financial instrument at a specified price on or before a specific date. A put option, on the other hand, gives the options buyer the right, but not the obligation to sell an underlying financial security at a specified price on or before a given date.
What is the expiration date and the strike price?
In derivatives trading, the expiration date is the last day that an options or futures contract is valid. The strike price is the predetermined price at which a holder has agreed to buy or sell an underlying asset.
What is ITM, OTM and ATM option?
Any option having an intrinsic value is classified as an “In-the-Money” (ITM) option. Any option that does not have an intrinsic value is known as an “Out-the-Money” (OTM) option. In some cases, when the strike price is almost equal to the spot price, it is called (At-the-Money) option.