Definition of Stock Options
Stock options are the 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 put option.
There are two styles of stock options, American and European. The American stock options provide the flexibility of exercising 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 expiration date of the option is also chosen by the trader and it represents the validity period for the contract. Then there is strike price which represents the price agreed between the contract holders at which the contract will be executed at the future date irrespective of the market price. The party purchasing the right to buy or sell the underlying stock pays a premium to the other party against such right obtained.
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 price 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 that the buyer of the option pays to another party for getting the right to buy or sell the underlying security. It represents the maximum profit that the seller of the option can get.
- The buyer of the stock option has the option to 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 then the buyer can choose to not exercise the option in which case the contract shall lapse.
- Call Option: A trader buys a call option at the strike price of $50 per contract, the expiration date is in six months. The current price of the stock is $35. At the expiration date, the price goes up to $65. The trader can reap out the profit by purchasing at the strike price of $50 per contract and selling it on the expiration date for $65. The profit would $15 per share.
- Put Option: A trader purchased 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 any time during the contract the trader can sell the option at $100 per share and make the profit for the difference between the strike price and market value.
- If the contract reaches the expiration date but the price of the put option does not dip below the strike price and does not rise above the strike price in case of the call option, the contract will be worthless and will expire.
Types of Stock Options
Mainly, there are two types namely call option and 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: In this type of 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 easily.
- Over the Counter Options: These options are traded on over the counter (OTC) market; they are less accessible to the general public.
Stock Options for Employees
Employee stock options are provided by the companies to their employees as a part of equity compensation. Companies allocate their employees and executive the stock options instead of allocating them the direct shares of the company. These give the employees an option to buy the company’s stock at a predetermined price and time. Terms of the employee stock options (ESOs) are defined by the company and laid down in the form of employee stock agreement.
ESOs only give employees the right to buy; they cannot be sold like standard listed shares or stock options. Employees reap out the benefit when the stock price goes above the exercise price of the stock option. All ESOs have a vesting period, i.e. the time period for which 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 dividend 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 available for all the stocks all the time; therefore, it limits the possibility of trading.
Stock options if used properly can fetch a very good return for the investors. They are most beneficial for experienced investors or investors with low capital for investment. Employee stock option, on the other hand, is also used for retaining the employees; this is the reason these stock have a vesting period attached to them. All in all, the stock option is a very good investment option for anyone who wants to get exposure 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 –