Put Warrant: Meaning, Benefits, Criticism

What Is a Put Warrant?

A put warrant is a type of security that gives the holder the right, but not the obligation, to sell a given quantity of an underlying asset for a specified price on or before a preset date. A put warrant is a company-issued option to sell back to the issuer a specified number of shares of the company's common stock at a particular price sometime in the future.

Understanding Put Warrants

There are two types of warrants—put warrants and call warrants. All warrants have an expiration date, which is the last day that the rights of the warrant can be exercised. If investors do not exercise a warrant before the expiration date, it becomes worthless. A put warrant's exercise price, also called the strike price, is the price at which the holder can sell the warrant. Both put and call warrants are classified by their exercise style. American warrants can be exercised anytime on or before the expiration date. On the other hand, European warrants can only be exercised on the day of expiration.

As with put options, investors can use put warrants to hedge against falling stock prices. Both put warrants and put options give the holder the right, but not the obligation, to sell an underlying stock on or before the expiration date at a strike price. They will be "in-the-money" if the price of the underlying stock is below the exercise price. Conversely, they will be "out-of-the-money" if the stock's price is above the strike price.

Unlike options, which investors trade on an exchange, companies issue warrants. If investors exercise the put warrants, they sell them back to the companies. Another fundamental difference between a put warrant and a put option is that the term for a warrant can last up to 15 years. Options have much less time to expiration—the vast majority expire within 12 months.

Benefits of Put Warrants

Put warrants have many of the same advantages for investors as put options, but there are a few differences. The main benefit of a put warrant is that the investor can limit potential losses. Limiting losses is most important when the company's shares are illiquid, which is usually the case for small companies. Investors may not be able to sell such a security quickly if unfavorable developments occur. Furthermore, an investment might be too large to use the options market effectively or, more likely, the company might be too small to have options at all.

The main benefit for companies issuing put warrants is the ability to attract large investments. Why should someone with $10 million to invest put it into a small unlisted company? After all, it will be harder to get the money back out than it would be with a large listed firm. By selling the large investor a put warrant, the company reduces this risk for the investor. Furthermore, selling warrants, like selling puts, is a bullish action that raises share prices. When a company sells put warrants, it is essentially promising to do a stock buyback at a preset price.

Of course, the ability to hold put warrants for many years also gives them an advantage over put options from the investor's point of view.

Criticism of Put Warrants

The main disadvantage of put warrants for investors is that they are issued by the same company that issues the stock. So, the issuer might not be able to honor the put warrants if the stock price actually falls. That is very different from exchange-listed put options, which are ultimately backed by an options exchange with a strong credit rating, such as the CBOE. Exchanges also require put writers to provide high-quality securities, such as Treasury bills, as collateral.

While investors buying put warrants from companies do not need to go so far as to demand Treasuries, having some type of collateral makes put warrants safer. When a larger company invests in a smaller company in the same industry, hard assets, such as plants and equipment, are often a good source of collateral.

From the issuing company's point of view, difficulty honoring put warrants when the stock price falls creates a different set of problems. At the very least, it could lead to cash flow issues at the worst possible time. If the company pledged vital assets as collateral, its ability to stay in business might be jeopardized by the need to transfer them to the put warrant holder.