search icon
      blog search icon

      What is a Stock Option? | Investing in Stock Options: What to Know?

      By Wasim Omar

      Published on

      May 26, 2023

      1:21 PM UTC

      Last Updated on

      July 28, 2023

      7:43 AM UTC

      What is a Stock Option? | Investing in Stock Options: What to Know?

      The stock option has a long and storied history in finance. The first recorded use of options can be traced back to ancient Greece, where farmers would purchase the right to use land at a later date.

      The modern version of options emerged in the 17th century in the Netherlands, where investors traded options contracts on tulip bulbs.

      In the United States, options trading began in the early 1900s, but it was not until the 1970s that options became widely available on exchanges.

      The use of stock options as employee compensation gained widespread popularity during the dot-com boom of the 1990s.

      Startups in the tech industry, which often lacked the cash to pay competitive salaries, offered stock options to attract and retain top talent.

      The idea of the stock option is also fundamental to investors and traders as a speculative tool, as it offers the potential for significant returns with relatively low upfront costs.

      What is a Stock Option?

      To begin our assessment, we begin with the most important question: what is a stock option?

      To keep it simple, a stock option is pretty much a contract that gives you the right to buy or sell a stock at a fixed price, by a fixed date, regardless of what its market price is.

      It is important to note that the ‘option’ aspect is fundamental to the contract as it gives the holder the right to exercise the option, as opposed to an obligation.

      As such, it offers market players the flexibility to act in a manner that is financially advantageous to them.

      Stock options are used in a wide variety of ways, for different contexts.

      Certain companies give them to employees as part of their compensation, while traders in the market use them to try to make money by betting on the future price of a stock.

      Stock options that give the holder the right to buy a stock at a fixed price, by a certain date, are known as call options, whereas those that give the holder the right to sell a stock at a fixed price, by a certain date, are referred to as put options.

      Characteristics of Stock Options

      Characteristics of Stock Options

      Explaining stock options is impossible to do so without a few crucial elements. These are described below:

      • Strike Price

        This refers to the specified price at which the underlying asset can be bought or sold by exercising a stock option.

      • Expiration Date

        Every option expires if not exercised before a certain date, causing the holder to lose the premium paid. This date is referred to as the expiration date.

      • Vesting schedule

        Often, stock options come with a set of conditions or a timeline under which employees become entitled to exercise their stock options.

        These conditions are called the vesting schedule and are crucial when options are used to deliver incentives.

      How Do Stock Options Work?

      As described above, stock options are contracts that give holders the right to buy or sell stocks at a fixed strike price before expiration.

      Let’s take the example of a trader buying call options on Tesla Inc. (NASDAQ: TSLA) stock.

      We assume the call option strike price of the option is $150, whereas TSLA is currently trading at $160.

      If a year later, the TSLA price rises to $200, the trader can exercise the option and buy the shares at $150, which is much cheaper than the current market price.

      This would then be sold back to the market, delivering an instant profit of $50 for each call option exercised.

      It is important to note that the higher the price of the stock the more beneficial exercising the option would be.

      If TSLA’s price would have dropped below the $150 strike price, the holder would simply let the option expire without exercising it.

      Types of Stock Options

      Having described generally what are options in stocks, we now turn to go over the two most widespread types of stock options seen in the real world. These are as follows:

      • Incentive Stock Options

        Incentive Stock Options (ISOs) are issued by companies to their employees to incentivize positive performance and align their goals with that of shareholders.

        ISOs are an effective way of attracting and retaining talent while ensuring employees are giving their best.

        These options essentially give holders a tax advantage upon exercising and are more profitable, the higher the price of the company’s shares.

      • Non-Qualified Stock Options

        Non-Qualified Stock Options (NQSOs) are similar to ISOs, in terms of acting as an incentive mechanism, but with one key difference.

        NQSOs do not meet IRS standards for preferential tax treatment, hence their being “non-qualified”.

        NQSOs are typically handed out to individuals, not on the payroll of the company, such as special consultants, independent board members, and other advisers.

      Trading Stock Options

      As you may have figured out by now, stock options are like a tantalizing playground for investors.

      Now, here’s the intriguing part: Yes, you can indeed buy and sell options in a market, known as the options market.

      When you buy a stock option, you’re essentially purchasing a contract that gives you the choice to either buy (call option) or sell (put option) the underlying stock.

      Think of it as having a ticket to potentially profit from the movement of the stock price, without actually owning the shares.

      As with any market, supply, and demand dictate option prices. Factors like the stock’s current price, time remaining until expiration, and volatility influence the value of options.

      Trading options can be a strategic endeavor. Some investors use them to speculate on short-term price movements, while others employ options to hedge their existing stock positions. The possibilities are endless.

      Example of Stock Options

      Employee Stock Options

      Let’s dive into an example to help you grasp the concept of the stock option.

      Imagine you want to invest in a company called Crunch, and you believe its stock, currently trading at $100 per share, is poised to rise in the next few months.

      You decide to explore options as a way to potentially profit from this anticipated price increase.

      You find a call option contract for Crunch with a strike price of $110 and an expiration date three months from now.

      The premium, or the price you pay for the option, is $5 per share.

      Now, let’s break it down. By purchasing this call option, you’re buying the right, but not the obligation, to purchase Crunch shares at $110 per share within the next three months.

      If Crunch’s stock price indeed rises above $110, your option can become valuable.

      Imagine that Crunch’s stock price soars to $130 within the three-month period.

      Since you hold the call option with the $110 strike price, you can exercise your right to buy the shares at $110 and then sell them in the market for $130, earning a profit of $20 per share (minus the premium paid for the option).

      However, it’s important to note that if Crunch’s stock price doesn’t surpass the strike price of $110 within the specified time frame, your option may expire worthless, and you would lose the premium paid.

      Employee Stock Options

      We now turn to a fascinating intersection between stock options and organizations:

      Employee stock options (ESOs). ESOs are a special type of stock option granted by companies to their employees.

      Stock options provide employees with the chance to participate as shareholders in the company they are employed.

      Let’s explore how ESOs tie into the world of options.

      When an employee is granted options, they receive the right to purchase a specific number of company shares at a predetermined price, known as the exercise price or strike price.

      These options typically come with a vesting period, meaning employees need to stay with the company for a certain period of time before they can exercise their options.

      ESOs can be a fantastic perk, as they align the interests of employees with the company’s performance and long-term success.

      If the company’s stock price rises above the exercise price, employees can exercise their options, purchase the shares at the predetermined price, and potentially profit from the difference between the exercise price and the current market price.

      ESOs can be a valuable incentive for employees, as they provide an opportunity to share in the company’s growth and success.

      They can also help attract and retain talented individuals, as employees have a vested interest in the company’s performance.

      How to Calculate the Value of Your Stock Options

      Alright, now that we have gone over options in-depth, let’s dive into how to calculate their value.

      Now, calculating the value of your options may seem like a complex task, but fear not. We break it down for you below:

      First things first, it’s important to understand that the value of stock options can fluctuate based on various factors, such as the current market price of the underlying stock, the strike price of the option, the time remaining until the option expires, and the overall volatility of the stock.

      So, let’s take a closer look at each of these components.

      • The Current Market Price of The Underlying Stock

        This is crucial because the value of your options is directly tied to the stock price.

        If the stock price is higher than the strike price of your options, you’re in luck.

        Your options are “in the money,” which means you have the potential to make a profit if you exercise them and sell the shares at the current market price.

        But if the stock price is below the strike price, well, your options are “out of the money” and their value may be lackluster.

      • The Strike Price of The Option

        Think of this as the special price that allows you to buy or sell the underlying stock when you decide to exercise your options.

        Keep an eye on how the strike price compares to the current market price of the stock.

        If the strike price is lower than the market price, your options have more value because you can buy the stock at a discount.

      • Time Remaining Until the Option Expires

        The time remaining until your options expire plays a crucial role in their value. Options with more time left until expiration tend to be more valuable.

        Why? Because they give you a longer window of opportunity to benefit from any potential price movements in the stock.

        As the expiration date gets closer, the value of your options may decrease, especially if the stock price stays fairly steady.

      • Overall Volatility of The Stock

        Volatility refers to how much the stock price tends to bounce around. If a stock is known for its wild price swings, it’s considered to be highly volatile.

        High volatility can impact the value of your options.

        When a stock is really jumpy, there’s a greater chance that its price will shoot past the strike price, making your options more valuable in the process

      How to Exercise Your Stock Options

      Once you’ve got a hold of options, the next step is understanding how to exercise them. Here’s a step-by-step guide on how to exercise them:

      • Confirm Eligibility

        Double-check if you meet the requirements to exercise your options, and reach out to your HR department or stock plan administrator in the case of employee options.

      • Gather Information

        Have the details handy, such as the number of options, strike price, and expiration dates.

      • Contact Brokerage or Employer

        Get in touch with your brokerage firm or stock plan administrator to initiate the exercise process. They’ll guide you through it.

      • Complete Required Forms

        Fill out any necessary forms accurately, providing the requested information.

      • Determine Payment Method

        Decide how you’ll pay for the shares—cash, cashless exercise, or stock swap—based on your financial situation.

      • Review and Submit

        Double-check all the information, ensuring accuracy, and submit the exercise request as per their instructions.

      • Settlement and Confirmation

        The shares will be transferred, and the funds or shares will be debited from your account. You’ll receive confirmation of the transaction.

      Types of Stock Option Plans

      When it comes to stock option plans, it’s crucial to be aware of the different types out there.

      Understanding these variations can give you a leg up in making informed investment decisions.

      So, let’s dive into three common types of stock option plans:

      • Fixed Value Plan

        In a Fixed Value Plan, the value of the stock option is set in stone from the get-go.

        With this, you know exactly how much profit you can potentially gain with each option.

        This type of plan is perfect if you prefer a predictable outcome, as it takes away some of the uncertainty and gives you a clear idea of what you’re in for.

      • Fixed Number Plan

        The Fixed Number Plan is a bit different. Instead of a predetermined dollar value, this plan assigns you a specific number of options.

        It doesn’t matter if the stock price goes up or down; you’ll always get the same number of options.

        This plan is great if you value stability and consistency. No surprises here, folks!

      • Megagrant Plan

        With this type of plan, eligible participants are granted a hefty chunk of options.

        These plans are usually used by companies to reward and retain their star performers or key employees.

        But here’s the catch: Megagrants often come with vesting schedules or performance milestones.

        They want to make sure you stick around or achieve specific goals before you can fully cash in on them.

      Taxation of Stock Options

      As is evident from the previous answer, taxation can significantly impact the outcome of exercising a stock option. Below are the most important dimensions of the role of taxation of stock options to keep in mind:

      • ISOs vs NQSOs

        As already discussed, ISOs include a tax advantage for their holders, whereas NQSOs do not.

        The taxation of an NQSO is subject to certain conditions, such as holding the stock for a certain period, while NQSOs are taxed at the time of exercise.

      • Taxation at Exercise

        For certain options, such as NQSOs, the cost of taxation is incurred only if and when the holder chooses to exercise the contract.

        The taxable income typically is the difference between the strike price and the prevailing market price of the stock when exercised.

      • Taxation at Sale

        When a market participant acquires a stock at a discount, using exercising a call option, and then sells that stock at the prevailing market price, it would be subject to capital gains tax.

      Advantages of Stock Options

      • Opportunity for Financial Gain

        Stock options can provide an opportunity for financial gain if the stock price increases.

        If the stock price goes up above the strike price, holders can exercise their options and make a profit by selling the stock at a higher market price.

      • Attracting and Retaining Talent

        Offering stock options as a form of compensation can help companies attract and retain talented employees.

        Employees may see them as something that offers the potential for future financial gain and aligns their interests with the company’s success.

      • Motivating Employees

        Stock options can motivate employees to work towards achieving the company’s goals.

        By tying their compensation to the performance of the company, employees may feel more invested in the success of the company and work harder to achieve it.

      Disadvantages of Stock Options

      • Risk of Financial Loss

        Stock options come with the risk of a financial loss if the stock price decreases.

        If the stock price goes down below the strike price, employees may not exercise their options and may lose the opportunity for financial gain.

      • Dilution of Stock Ownership

        Issuing stock options can dilute the ownership stake of existing shareholders.

        When a stock option is exercised, new shares of stock are issued, which can decrease the ownership percentage of existing shareholders.

      • Complexity of Stock Option Plans

        Stock option plans can be complex and difficult for employees to understand.

        Employees may not fully understand the potential tax implications or the vesting schedule, leading to confusion or frustration.

      Stock Options vs Other Equity Compensation

      It is important to point out that stock options are not the only form of equity-based compensation that companies pay to their employees.

      Below, we compare three different types of such compensations with stock options:

      • Comparison to Restricted Stock Units (RSUs)

        Options and RSUs are both forms of equity compensation.

        However, stock options provide employees with the option to purchase shares at a set price, while RSUs provide employees with actual shares of stock that vest over time.

      • Comparison to Employee Stock Purchase Plans (ESPPs)

        Both stock options and ESPPs are forms of equity compensation.

        However, ESPPs allow employees to purchase shares of company stock at a discount, while stock options provide the option to purchase shares at a set price.

      • Comparison to Stock Appreciation Rights (SARs)

        Stock options and SARs are similar in that they provide employees with the opportunity for financial gain if the stock price goes up.

        However, SARs do not require the purchase of actual shares of stock but rather provide employees with the difference between the fair market value of the stock at the time of exercise and the initial grant price.

        Stock options, on the other hand, require the purchase of actual shares of stock at the exercise price.

      How to Value Stock Options

      Valuing stock options can be complex and involves several factors. The two main methods of valuation are the Black-Scholes model and the binomial model.

      Both models take into account the current stock price, strike price, time until expiration, volatility, and interest rates.

      Additionally, to work out the intrinsic value, it’s important to consider the specific terms of the option, such as the vesting schedule and any restrictions.

      Determining the fair market value stock option can be particularly challenging for privately held companies, as the lack of a public market for the stock can make it difficult to determine the fair market value.

      Risks and Considerations

      It is important for investors attracted by the prospects of the stock option to maintain a holistic view and consider the risks that come with it.

      Risks and Considerations

      In this spirit, we have detailed the most crucial risks associated with stock options:

      • Fluctuation In Stock Price

        Stock options come with the risk of a financial loss if the stock price decreases.

        If the stock price goes down below the strike price, employees may not exercise their options and may lose the opportunity for financial gain.

      • Concentration Risk

        Stock options can be concentrated in one company’s stock, which can result in a lack of diversification in an employee’s investment portfolio.

        This can lead to increased risk if the company’s stock performs poorly.

      • Liquidity Challenges

        Stock options can be illiquid and difficult to sell, particularly for employees of privately held companies.

        This can make it challenging for employees to access the potential financial gains from their stock options.

      Conclusion

      Investing in stock options can be a valuable tool for both market participants and employees.

      Stock options are a widely-used financial instrument with the potential to provide significant financial gain or loss.

      Whether you are an employee offered stock options as part of your compensation package, or an investor looking to profit from changes in the stock market, understanding the basics of stock options can help you make informed decisions and manage your risks.

      Stock options provide an opportunity for financial gain, can attract and retain talent, and motivate employees to work toward the success of the company.

      However, there are risks associated with stock options, such as stock price risk, concentration risk, and liquidity risk.

      FAQs

      Why Would You Buy an Option?

      Options provide the potential for higher returns and flexibility, allowing you to profit from price movements without the need to own the underlying stock outright.

      What Are the Two Main Types of Stock Options?

      The two main types of stock options are call options, which allow you to buy the stock at a predetermined price, and put options, which give you the right to sell the stock at a predetermined price.

      How Do Stock Options Work?

      Stock options work by granting you the right, but not the obligation, to buy or sell a specific amount of stock at a predetermined price within a specified time period, giving you the opportunity to profit from price fluctuations.

      More From Stocks telegraph