Stock Market Investing 10 Minute Guide - page 37

For example, suppose that you have just purchased 10 shares of XYZ Company stock at $10 per share. XYZ Company knows that, as a new company, it may have a little difficulty finding new investors in the market right now, so the company attaches a warrant to each share that you have just purchased (free of charge, no less). The warrant entitles you to buy a share of XYZ Company stock for $11, regardless of what it's selling for on the market. Since you have just bought the stock for $10 per share, it would be kind of silly to pay $11 per share right now.

But, in the course of time, the price of XYZ Company rises to $13 per share. By cashing in your warrants, you could buy 10 more shares of XYZ Company stock at the price of $11 per share, thereby making an immediate profit of $20 ($11 — 10 = $110, versus $13 — 10 = $130).

Let's say that when you purchased those 10 initial shares and received the warrants, you were satisfied because you really only wanted 10 shares to begin with. You figured the warrants were nice but relatively useless, right? No. As in the subscription rights example, you can sell or otherwise dispose of warrants however you see fit. Therefore, if the price of XYZ Company stock rises to $13 per share, you have 10 warrants to use for purchasing that stock at $11 per share.

I'm an investor who wants to purchase XYZ Company stock, so you offer to sell me your warrants for $1 each. I use your warrants to purchase XYZ Company stock at $11 per share, and I still save $10 ($11 — 10 = 110 + $10 = $120, versus $13 — 10 = $130). You've just made $10 by selling me something you didn't want to begin with, and XYX Company has attracted a new investor. Everybody's happy.

More on Warrants

Many investors buy and sell warrants, completely ignoring the underlying stock, because oftentimes more money can be made from the warrant transactions. For example, let's say you bought those 10 warrants from me at $1 each. Instead of using them to buy stock, you hold on to them and wait until the price of XYZ Company stock climbs to $14 per share. You then find another investor who is willing to pay $2 per warrant. The advantage to the buyer is that he or she acquires the right to buy XYZ Company shares at the bargain price of $11 each. The buyer will still save $10 in the transaction ($2 — 10 warrants = $20 and $11 — 10 shares = $110; $20 + $110 = $130, versus $140 to purchase 10 shares at $14). The investor has saved money, and you have made $10 from your initial $10 investment, effectively giving you a 100-percent profit.

Of course, if the price of XYZ Company stock never rises above $11 per share, you've just bought a dog with fleas. Welcome to the wonderful world of investing.

Also, it should be noted that XYZ Company is not issuing warrants for the sake of being nice. As noted in the previous example, companies typically issue stock because they are relatively young and/or may have a difficult time otherwise attracting new investors. Since warrants are almost always issued at a higher purchase price than what the stock is currently selling for, the company and the recipients of those warrants are all betting that the price of the stock will rise. Many times, those recipients are other companies or are brokerage houses, because companies often will pay each other off through the transfer of warrants. As in the example when no actual stock changed hands, these brokerage houses and companies will then sell the warrants to individual investors in order to raise cash without having to make a capital investment of their own, or with only a minimal one. In addition, this action effectively launches the warrants onto the common market for everyone to buy and sell.