Definition of Stock Options
Stock options are financial instruments wherein a contract is formed between two parties, and such a contract gives the holder of the instrument a right but not an obligation to buy or sell the underlying stock at the predetermined price till an agreed date. The stock options are traded on stock exchanges like ordinary stocks. There are two types of stock options, namely the call option and the put option.
There are two styles of stock options, American and European. The American stock options allow the option anytime between purchase and expiration date, whereas European style options can only be exercised on the expiration date. European options are less commonly used.
The trader also chooses the option’s expiration date, representing the contract’s validity period. Then there is strike price which means the price agreed between the contract holders at which the contract will be executed at a future date irrespective of the market price. The party purchasing the right to buy or sell the underlying stock pays the other party a premium against the such right.
How Does it Work?
Usually, a stock options contract represents 100 shares of underlying stocks. The price of the stock options moves in line with the cost of the underlying stocks on stock exchanges, i.e., the price of the stock option will rise and fall according to the price of the underlying stocks. Some of the important points associated with the stock options working are as follows:
- Call option and put option: The call option gives the option holder right to buy the stock at a predetermined price on a set date, while a put option gives the option holder right to sell the stock at a predetermined price and date.
- Strike price: A strike price is a price at which the option holder will exercise the option.
- Premium: Premium is the amount the buyer of the option pays to another party to get the right to buy or sell the underlying security. It represents the maximum profit that the seller of the option can get.
- Stock buyer: The buyer of the stock option can exercise the option, i.e., buy the security in case of a call option and sell the security in case of a put option anytime before the expiry of the contract at the strike price irrespective of the strike price. If the prices are unfavorable, the buyer can choose not to exercise the option, which means the contract shall lapse.
- Call Option: A trader buys a call option at the strike price of $50 per contract; the expiration date is six months. The current price of the stock is $35. At the expiration date, the price goes up to $65. The trader can reap the profit by purchasing at the strike price of $50 per contract and selling it on the expiration date for $65. The profit would be $15 per share.
- Put Option: A trader purchases a put option at the strike price of $100 per share or contract; the option will expire in six months. The current price of the stock is $115 per contract. Now, if the price dips below $100 at any time during the contract, the trader can sell the option at $100 per share and make a profit from the difference between the strike price and market value.
- Contract Option: If the contract reaches the expiration date, but the put option price does not dip below the strike price and does not rise above the strike price in the case of call option, the contract will be worthless and expire.
Types of Stock Options
Mainly, there are two types, namely, call option and the put option. But there are other ways as well in which the stock options can be categorized.
- Call Option: The call option gives the holder right to buy the option at the agreed time and price.
- Put Option: The put option gives the holder right to sell the stock option at a predetermined time and price.
- American Style: It is more related to the term of the contract; in this type of contract, the option holder has the flexibility to exercise the option anytime between the date of purchase and the expiration date.
- European Style: This contract option can only be exercised on the expiration date.
- Exchange-Traded Options: These stock options are listed on the stock exchange and can be bought and sold quickly.
- Over the Counter Options: These options are traded on the counter (OTC) market; they are less accessible to the general public.
Stock Options for Employees
The companies provide employee stock options to their employees as a part of equity compensation. Companies allocate their employees and executive stock options instead of allocating them the direct shares of the company. These allow employees to buy the company’s stock at a predetermined price and time. Terms of employee stock options (ESOs) are defined by the company and laid down in the form of an employee stock agreement.
ESOs only give employees the right to buy; they cannot be sold like standard listed shares or stock options. Employees reap the benefit when the stock price goes above the stock option’s exercise price. All ESOs have a vesting period, i.e., the time period the employee will have to hold the stock option. This feature limits the employees’ ability to exercise the option. ESOs are taxed when the option is exercised. They do not include any dividends or voting rights.
Benefits of Stock Options
Benefits are given below:
- Stock options are more cost-efficient when compared to a similar stock position.
- When used diligently are less risky than the stocks themselves.
- They are more profitable since less money is spent on their purchase, thus more profit.
- They are flexible in terms of the fact that they provide more investment alternatives.
- Options do not require high capital requirements to invest in them.
Limitations of Stock Options
Limitations are given below:
- Stock options have lower liquidity when compared to a similar stock position.
- Options trades cost a high commission, which makes them costly.
- They are complex to understand, especially for new investors.
- Options are not always available for all the stocks; therefore, it limits the possibility of trading.
Stock options, if used correctly, can fetch a very good return for investors. They are most beneficial for experienced investors or investors with low capital for investment. On the other hand, the employee stock option is also used for retaining employees; this is why these stocks have a vesting period. The stock option is a very good investment option for anyone who wants exposure to trading with lesser risk.
This is a guide to Stock Options. Here we also discuss the definition and How do stock options work? along with benefits and limitations. You may also have a look at the following articles to learn more –