Warrants are investment instruments that enable investors to purchase company stock at a specific price. Ideally warrants are issued by financially stable companies with high-growth prospects, and that are seeking an alternative mechanism of capital asset management. The decision to purchase using warrants is optional; if the warrant is not used, the initial cost of financial instrument is forgone. Warrants are exercised within a time frame determined by the conditions of the warrant. Several advantages and disadvantages exist with these types of investments.
Pros
• Longer time horizon
A key advantage of warrants is they offer a long-term time horizon according to Investopedia. This means investors can wait several years before buying underlying shares. With time, the probability of a company’s share price surpassing the warrant’s strike price is higher if the market conditions and business fundamentals permit it.
• Alternative to standard options
Warrants also offer an alternative to standard stock options; this can improve investment diversity and allow investors to profit from more dynamic market circumstances. For example, purchasing shares directly as well as a warrant make dollar-cost-averaging possible in addition to hedging risk associated with purchase price.
• Improved capital management
A third benefit of investing in warrants is the opportunity to leverage an investment. This is because warrants, like stock options, are classified into groups of shares. Since the shares do not have to be purchased immediately, but the right to buy at a specific price is, investors can better manage capital by accumulating incrementally rather than right away via margin or credit.
Cons
Investing in warrants is not without its downsides. Moreover, warrants issued by company’s seeking to create additional capital incentive to investors do not always do so for the right reasons i.e. when the company is insolvent or at risk of bankruptcy. It is for this and other reasons having to do with investment analysis that Inacademy recommends warrants only be invested by experienced investors.
• Substantial risk
Like many financial investments not insured by the Federal Deposit Insurance Corporation there is substantial risk. Several types of investment risk apply to corporate investments per the Financial Regulatory Authority (FINRA). Among those that influence warrants are credit risk, managerial risk, liquidity risk and possibly inflation risk.
• Opportunity cost
Opportunity cost is the difference between return on investment among two or more investments. For instance, if a warrant costs $1,000 up front, but yields a 10 percent ROI in five years, and a Californian Municipal Bond also costs $1,000 and yields a 12 percent ROI for the same period, a two percent opportunity cost is incurred by investing in the warrant.
• Infrequently issued
Another disadvantage of warrants is they are not as common as regular stock options within the U.S. securities market. This is because they are less utilized as a financial instrument by many companies and because warrants do not trade in the same markets as regular stocks. The result of this limited availability and restricted trading capacity reduces the choices of warrants and the ease of investing in them.