Everything You Need To Know About Stock Options
/A growing number of companies are offering stock options as a part of the overall compensation package. Stock options are also a unique investment vehicle outside of the compensation package version. If you are new to investing, you may be wondering what a stock option is. For many new traders and investors, stock options can seem difficult to understand.
If you are new to investing, or options trading, or want to add stock options to your investment portfolio, then here is everything you need to know about stock options.
What is a stock option?
A stock option is a contract that you purchase, giving you the right, but not the obligation, to buy or sell the underlying asset of the stock in question at a specific price, known as a strike price, from/to the seller (writer) by a certain date. In simple terms, it gives you the opportunity to own a portion of the company you work for and cash in once the organization goes public or is acquired.
A buyer of a stock option contract is called an option holder. A seller of a stock option contract is called an option writer. Usually, the seller uses an equity management software for large companies to manage the stock options. There are two stock options: stock call options and stock put options. A stock call option contract gives the buyer (holder) the right to buy a stock while a stock put option gives the buyer to sell a stock.
Stock options trading allows you to lock in a stock share price at a future date if you want to buy or sell a stock option contract, but you have the right to exercise your option to buy or sell or let the stock option contract expire if the stock's price is not profitable.
Stock option languages
If you are looking for information about different stock option contract languages or terms, here is everything you need to know about stock option contract languages:
Writer
The investor who sells the stock option contract and receives the premium from the holder. The writer is obligated to sell or buy the stock if the holder exercises the option.
Holder
The investor who owns the stock option contract is the holder. A call holder has the option to buy the stock option contract and a put holder has the right to sell a stock option contract.
Premium
The stock option contract premium is the price per share paid by the stock option holder (buyer) to the seller for the stock option contract.
Strike Price
A strike price is the price that a stock option contract can be exercised. As a stock option holder, you use a strike price to lock in the future price of a stock. When you exercise the contract, the stock share will be bought (if you buy a stock call option) or sold (if you buy a stock put option) at the strike price.
Contract
A stock option contract refers to the specific stock shares you can purchase or sell at a predetermined price (strike price) by the expiration date of the contract. A standard stock option contract usually consists of 100 shares.
Call options
A stock call option is the option to buy a stock for an agreed-upon price (strike price) by a specific date.
Put options
A stock put option is the option to sell a stock option contract for an agreed-upon price by a specific date.
At the Money
When the market price and the strike price of the stock are the same, your stock option contract is at the money.
In the Money
For the call stock option, if the current market price of the stock is above the strike price, you are in the money, i.e. you make money. For the put stock option, if the stock's current market price is below the strike price, you make money.
Out of the Money
When the price of a stock is below the strike price, you are out of the money, i.e. the price of the stock is unfavorable to you. The stock option buyer or investor loses money if he or she is out of the money.
Expiration Date
The expiration date of a stock option contract is the date or time after which the stock option contract has no value. An expiration date can be as short as a day or as long as a few years into the future.
How does a stock option contract work?
A stock option contract is the option to buy or sell a stock for a specific price by a specific period of time. When you buy a stock option contract, you are called a holder or a buyer and when you sell a stock option, you are called a writer or a seller. You are a buyer if you are a call holder or a put holder. As a buyer, you are not obligated to buy or sell a stock option contract. Buying a call stock option or buying a put stock option limits your risk to only the premium you spent to buy a call or put stock option contract.
But if you are a seller, i.e. a call writer and a put writer, you are obligated to buy or sell a stock option contract if it expires in-the-money. Selling a stock option has exposure to unlimited risks, meaning sellers can lose much more money than the price of the stock option premium.
Typically, a stock option contract includes 100 shares. You can buy or sell a stock option contract by paying only the contract premium which is usually quoted for one share. For instance, if the premium of a stock option contract is $1 per share, then the total premium you will have to pay for a single stock option contract is $100.
If the current market price of the stock of a company is $30, and you think it is going to increase, then you can buy a call stock option to buy that company's stock. For instance, let’s say you want to buy a stock option contract of a company with a strike price of $35. If the price of that company's stock shares rise, to a market price of $40, then you could buy the stock from the seller at the strike price of $35 and then sell it immediately into the market to make $5 profit per share. Now multiple $5 by 100, which is $500. If you deduct the $100 premium from your gross profit of $500, your net profit would be $400.
But, if the market goes against you, you could let the stock option contract expire, as you are not obligated to exercise the option contract, and your loss would be $100. If the price drops, then you will want to let it expire, limiting your loss only to the premium you spent to buy the stock option.
Time is an important component of the price of a stock option. The more time there is until the expiry of a stock option contract, the probability of an increase in price in your favor increases, and vice versa. If you buy a one-month call stock option contract that is out of the money, and the price does not move, then it will be less valuable to you.
Why use stock options
Speculation
If you think that the price of a stock will go up based on your fundamental analysis or technical analysis, then you might buy the stock or buy a call option on the stock. A call option on a stock option contract may only cost a few dollars or even cents compared to the full price of the stock.
Hedging
You can reduce risk at a reasonable cost by trading stock options. You can trade stock options to insure your investments against a downturn.
For example, if you think that the stocks of a particular company will go up, then you could buy a stock options contract using a call option. But if you also want to limit losses in case the price moves against your trade, then you can use a put option to limit your risk while making money in a cost-effective way when the price of the stock goes up.
If you think that the price of a particular company's stocks will go down, then you can use a put option to sell a stock options contract as a short seller. But if you want to limit losses in case the price moves against your trade, then you can use a call option to limit your risk.
Compensation
As mentioned earlier, some companies are offering stock options as a part of the compensation package. This allows employees to cash-in when the company goes public or is acquired.
Types of Stock Options
There are two types of stock options: stock all options and stock put options.
Stock call options
When you want to buy a stock option contract, you use a stock call option. When you buy a stock options contract, you have the right, but not the obligation, to buy the stock for the agreed-upon price by a certain date. If you believe that the price of a particular stock will increase over time, then using stock call options can be a profitable investment strategy.
Stock put options
When you buy a stock put option contract, you have the option, but not the obligation, to buy the stock options contract for the agreed-upon price by a certain date. If you believe that the price of a stock will drop significantly, then buying a stock put options contract of that stock can be profitable
What are the benefits of stock options over stocks?
If you buy the underlying stock for $50 per share and the stock price plummets to $5 per share, you have taken a heavy hit if you decide to sell your stocks.
Requires a small upfront capital investment
Stock option trading requires a lower upfront capital than stock trading. Trading stock options allow you to buy a stock share with much less money than you would need to buy a stock share with stock trading.
Minimize your risk
You can minimize your risk by trading stock options. If you buy a call option for $15, betting that the stock price will increase, and then the price of that stock option falls, you can just let the option expire and cut your losses. As an options trader, you do not have to exercise the right to buy that share because it is not profitable. Your loss would be just $15.
Potential returns
You can buy stock shares at a price lower than its current market value. Then you can sell them at their current market value.
Cons of trading stock options
If you are the options writer, there is increased risk of selling options contracts. You are exposing yourself to limitless risk. But the risk of the holder of the stock option contract is limited only to the premium paid to buy the stock option. On the other hand, the options writer can lose additional money on top of the premium paid by the holder.
Stock options have expiration dates. When you invest in stock options, your contract has a finite life span before you must exercise your option or forfeit it. But when you trade stocks, you technically have an indefinite time frame for your stock to yield favorable results. That means if your stock declines in value, you still have the opportunity to hold onto it, in case the stock's value climbs up.
In conclusion
Trading stock options do not have to be difficult to understand once you learn everything you need to know about stock options. If you are interested in trading traditional stock options, it is essential to understand the risks involved in trading stock options and determine the probabilities of future price movements of the stock shares of different companies based on fundamental and technical analysis.
Disclaimer: the content presented in this article is for informational purposes only, and is not, and must not be considered tax, investment, legal, accounting or financial planning advice, nor a recommendation as to a specific course of action. Investors should consult all available information, and consult with appropriate tax, investment, accounting, legal, and accounting professionals, as appropriate, before making any investment or utilizing any financial planning strategy.
