In this writeup, we'll be looking at financial instruments
called warrants. Now, we could talk about this for a long time,
but in fact, warrants are simply options that are not backed by the
exchange. In the rest of this writeup, we'll focus on the differences
between warrants and options. This assumes a certain familiarity with basic
option theory, that can be found in the appropriate node. If you
know this, congratulations - you understand 95% of what there is to know
about warrants. The rest is mainly some technical details that are mostly harmless nonetheless can bite.
The first implication of the difference between warrants and options is that
warrants and options are not fungible (fungibility apparently has nothing
to do with fungus, unless you store the contracts in a wet
place). In other words, if we are long a warrant, and short an option,
we can't close the position, even if strike and expiry are the same.
The warrant represents a contract with the issuer, and the option a
contract with the exchange, and we can's simply assume they are the same
contract partner.
Secondly, it is not possible to short a warrant. Quite simply, the
issuer has sold the obligation to honor the contract - usually to sell
you the shares, as most warrants are calls. Only the issuer can
create these warrants, and by shorting, you would assume the
obligation to deliver shares on the issuer's behalf. That's just plain
weird, not to mention messy at settlement. So, remember: don't short
warrants. It's illegal. A consequence of this is that it is possible for
warrants to be more expensive than the equivalent option. It is not possible
to arbitrage the difference by selling the warrant and buying the option,
netting cash: selling the warrant is not possible if one has no position.
The third difference between warrants and options is that a warrant can have
any form the issuer wants. Any expiry, any price, any contract size, and it
is even possible to have a different underlying, such as a basket of
shares. In particular, warrants are often used to create long-dated options.
The last, and probably main difference between warrants and options stems
from the fact the obligation to deliver the shares comes from the
issuer. Now, if the issuer is the company itself, that does not really
matter - if the company goes bankrupt, the option is worthless anyway.
However, if the issuer is someone else, this does create a problem.
Imagine Lehman Brothers sold you a warrant in 2008 on a stock that
happened to weather the crisis. Too bad, you lost your money anyway,
because Lehman defaulted. This credit risk means that a warrant issued by
a third party should be worth less than the equivalent option, as there is
a chance the contract won't be honored. However, we have just seen that
because it's not possible to short a warrant, a warrant might in fact be
more expensive than the equivalent option. This may help one to choose
between buying the warrant or the option.
In the discussion above, we have briefly explored the main differences
between options and warrants. In a nutshell, warrants are options that are
not backed by the exchange, but by a third party. This means the contracts
are inherently different, in particular because a warrant contract could be
defaulted upon.
Oh, and those employee stock options? If they are
issued by the company, they are technically warrants. And by the way, this is not investment advice - so don't come complaining if you thought it was and it cost you money.