Top 5 advantages and disadvantages of call warrants with examples

Summary:

While call warrants may be a go-to choice for many investors before you take them up, it’s best to know what you’re getting into. Here we’ve enlisted the top 5 advantages and disadvantages that come with this instrument. Carefully read through them, so you make an informed decision when you invest.

Introduction

Stocks are a well-known investment option that anyone can access with relative ease. However, even for savvy investors, it’s not easy to navigate the complexities of the stock market. And call warrants fall right into this bracket.

That being said, you shouldn’t neglect call warrants due to their complexity. Once you understand the concept, you’ll see that they have several unique features that play to your advantage. Especially, the potential returns it offers very few other vehicles give the same.

No doubt, it has two sides - both advantages and disadvantages. Before you instantly back off, be opportunistic and educate yourself on everything you stand to gain from this instrument.

Now, let's dive into the good and the bad of call warrants.

Advantages of call warrants

Call warrants are a preferred option for a plethora of reasons. It allows you to spread your risk, control larger investments with little investment, and make more money. Plus, you can use them when you please - offering lots of flexibility.

Here are the advantages, so you know why it’s a sought-after investment method.

1. Large returns in the long-term

With warrants, they offer a major advantage - long-term investment. It’s an advantage because with time, the chances of the share price surpassing the strike price (predetermined price) are higher. How it works is, you purchase the asset at a low strike price and sell it when the market price is higher. This way you can earn higher profits.

2. Higher leverage

As compared to simply purchasing shares of a common stock, warrants offer more leverage. They come with a relatively lower investment and allow the investor to control a larger number of shares. This also can possibly result in an increment in the potential returns on the investment.

3. Increased flexibility

Based on favourable market conditions, you have the flexibility to decide when you want to sell the warrant. You can wait until the asset's price reaches its peak and sell. You can do so any time before expiration.

4. Long-term value

Typically, warrants do not expire very quickly. They have a lifetime of 5,10, sometimes even 20 years. This means you can buy and hold on to a warrant for an extended duration without worrying about expiration dates, unlike options contracts.

5. Lower price and limited risk

In comparison to the open market, investors can purchase warrants at a lower price.

Along with reduced prices, the risk is low too. With warrants, the maximum you can lose is the price that you purchased it for. So without risking your initial investment, you have the chance to gain higher profit.

6. Diversification

Without actually purchasing multiple assets, you can diversify your portfolio with call warrants. This is because you can invest in a variety of call warrants on different underlying assets, which ensures you diversify and spread the risk.

Criticisms of call warrants

In the world of finance, where opportunities exist, so do risks. And this holds good with call warrants too. Underneath all those advantages, there’s a few drawbacks that you might want to consider. It’s best to uncover them early on, so you know what you’re getting into before it’s too late.

1. Time decay

Like all good things, call warrants also have an expiry date. The closer this date approaches, the lower the value goes of the asset, and eventually upon expiry, it’s worthless. Time decay here means the longer you hold on to a call warrant, the more it loses its value.

2. Potential loss

Where there’s profit, there’s loss. With call warrants, after you buy the asset, if the market doesn't move in the direction you anticipate or doesn’t go above the strike price, you risk losing your entire initial investment.

3. High complexity

For those who are new or unfamiliar with the stock market, call warrants can be a complex instrument. There are several intricate concepts which you need to get familiarised with, and this may be a challenge. The lack of knowledge can cause you to make bad decisions.

4. Infrequent utilisation

Compared to regular stock options, warrants are used less in the securities market, as they’re not traded in the same market as regular stocks. This curtails the availability and trading capacity, further limiting the choice of warrants.

5. Lower liquidity

Warrants are known to be illiquid in nature. The reason being, at a time when you want to buy or sell, it’s difficult to find buyers or sellers. This lack of liquidity can make it difficult for investors when they want or need immediate funds.

Examples of call warrants

Here are some examples to help you understand the concept better.

Examples of advantages of call warrants:

1. Potential profit

Say you buy a warrant from Company B with a strike price of Rs. 1000. If the price of the stock rises to Rs. 2000, you can exercise the call warrant to buy the stock at Rs. 1000 and sell it at the market price of Rs. 2000, making a profit of Rs. 1000.

2. Leverage

Say you want to invest Rs. 1000 in a call warrant with a leverage ratio of 5:1. Your Rs.1000 investment allows you to control a position in the underlying stock worth Rs. 5,000. If the price of the stock rises, you can make a potential profit of 10% based on the Rs. 5000 you control, giving you a profit of Rs. 500 (10% of 5000).

3. Diversification

When you buy call warrants, you can buy them across a range of assets like commodities, currencies, equity, etc.

Examples of disadvantages of call warrants:

1. Time decay

Say you purchase Company G’s stock at a strike price of Rs. 1000 and the warrant has 6 months of life left. Even if the company’s stock price is constant, your warrant’s value may decrease as the date of expiry nears.

2. Loss of premium

You can purchase a call warrant for Rs. 5000 with an expectation that the stock price will increase. However, if the price doesn’t budge or lowers, you will lose your investment of Rs. 5000.

3. Complexity

Being a novice investor, you may purchase call warrants without fully grasping the concept. Due to this, you might not fully understand the risk-reward profile and make poor investment decisions.

In conclusion

As you read, call warrants have some solid advantages but also some limitations. As an investor, you must carefully consider both sides before you decide to choose this instrument.