Do many investors hold warrants to maturity? Is it advisable to do so? Why or why not?
Before we address the question lets first look at why an investor would buy a warrant in the first place. The number one advantage of warrants is ‘gearing’. That is, warrants give a holder exposure to a larger parcel of shares than if they purchased the shares directly with the same investment amount. The other advantage of warrants is that the holder is not obliged to make the second payment, so while the holder has effective exposure to a larger amount of stock they are only risking the initial cost of the warrant. In return for these advantages the holder of a warrant pays a ‘premium’ that is built into the price of the warrant.
In order to explain ‘premium’ we will use an example. Say an investor purchased a call warrant for $0.50 which had an exercise price of $5.00, while the shares are currently trading in the market for $5.25. If the investor holds the warrant to maturity and exercises it to buy the shares they would effectively be paying $5.50 for the shares ($0.50 warrant cost + $5.00 exercise price). If you consider the alternative of buying the shares on the market at $5.25, you can see that the investor is paying a $0.25 premium by purchasing the warrant. This $0.25 premium is often expressed as a percentage of the underlying share, in this case 4.8% ($0.25 / $5.25).
The premium of the warrant is also referred to as “time value”, it is the cost the holder pays in return for the advantage that the gearing provides. Premium (or time value) will decay over the life of the warrant (called time decay) so that when it reaches the expiry date, premium will always be zero. Therefore a holder of a warrant cannot usually afford to hold the warrant if the share price does not move in their favor. In the above example, if the share price did not move between the time of purchase and expiry, the $0.25 premium would decay to zero and the warrant would be worth only $0.25. It is useful for holders to calculate the premium of a warrant as it will provide an estimate of how much the warrant will decay between now and expiry.
So, the answer to the above question is ‘no, investors usually do not hold warrants to maturity’, normally investors will simply buy and sell warrants as they move with reference to movements in the underlying shares. If you plan to hold a warrant for a long period you must consider the cost of holding, ie. the time decay. Another useful calculation is to estimate how much a warrant will decay over a period shorter than expiry. Say in the above example of a warrant with a $0.25 premium. If there were 5 months until expiry the holder can make a rough estimation that the warrant will decay approximately $0.05 per month ($0.25 / 5). In reality, time decay in warrants is not linear and actually speeds up closer to expiry, however the estimation may be used as a reference and can assist in the decision of how long to hold a warrant.
There are situations where it may make sense to hold a warrant to maturity. If the underlying shares are continuing to move in favor of the holder and the holder believes there are further gains to be made in holding the warrants when considering their target share price and the cost of decay. Holding a warrant to maturity in this case may be a viable strategy.
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