In this writeup, we'll be looking at financial instruments called warrants. Now, we could talk about this for a long time, but in fact, warrants are simply options that are not backed by the exchange. In the rest of this writeup, we'll focus on the differences between warrants and options. This assumes a certain familiarity with basic option theory, that can be found in the appropriate node. If you know this, congratulations - you understand 95% of what there is to know about warrants. The rest is mainly some technical details that are mostly harmless nonetheless can bite.

The first implication of the difference between warrants and options is that warrants and options are not fungible (fungibility apparently has nothing to do with fungus, unless you store the contracts in a wet place). In other words, if we are long a warrant, and short an option, we can't close the position, even if strike and expiry are the same. The warrant represents a contract with the issuer, and the option a contract with the exchange, and we can's simply assume they are the same contract partner.

Secondly, it is not possible to short a warrant. Quite simply, the issuer has sold the obligation to honor the contract - usually to sell you the shares, as most warrants are calls. Only the issuer can create these warrants, and by shorting, you would assume the obligation to deliver shares on the issuer's behalf. That's just plain weird, not to mention messy at settlement. So, remember: don't short warrants. It's illegal. A consequence of this is that it is possible for warrants to be more expensive than the equivalent option. It is not possible to arbitrage the difference by selling the warrant and buying the option, netting cash: selling the warrant is not possible if one has no position.

The third difference between warrants and options is that a warrant can have any form the issuer wants. Any expiry, any price, any contract size, and it is even possible to have a different underlying, such as a basket of shares. In particular, warrants are often used to create long-dated options.

The last, and probably main difference between warrants and options stems from the fact the obligation to deliver the shares comes from the issuer. Now, if the issuer is the company itself, that does not really matter - if the company goes bankrupt, the option is worthless anyway. However, if the issuer is someone else, this does create a problem. Imagine Lehman Brothers sold you a warrant in 2008 on a stock that happened to weather the crisis. Too bad, you lost your money anyway, because Lehman defaulted. This credit risk means that a warrant issued by a third party should be worth less than the equivalent option, as there is a chance the contract won't be honored. However, we have just seen that because it's not possible to short a warrant, a warrant might in fact be more expensive than the equivalent option. This may help one to choose between buying the warrant or the option.

In the discussion above, we have briefly explored the main differences between options and warrants. In a nutshell, warrants are options that are not backed by the exchange, but by a third party. This means the contracts are inherently different, in particular because a warrant contract could be defaulted upon.

Oh, and those employee stock options? If they are issued by the company, they are technically warrants. And by the way, this is not investment advice - so don't come complaining if you thought it was and it cost you money.