Whether you are a trader looking to diversify your portfolio or someone that has received stock options as part of your employee compensation package, there are a lot of nuances worth delving into. The following guide will look at stock options, how they work, key terms to consider, and the pros and cons of using them.
Stock options definition
Stock options are a form of equity compensation that gives the investor the right to buy a stock at a fixed price over a finite period of time. There are two primary types of options contracts: puts, which is a bet that the stock price will fall, and calls, which is a bet that a stock will rise. Generally, one options contract represents 100 shares of the underlying stock.
Employee stock options (ESOs) are a type of alternative compensation that many companies, including many startups, offer as a part of their benefits package for employees. ESOs function like a regular call option, rewarding the holder the right to purchase the underlying asset (the company’s stock) at a specified price for a specific time.
Understanding how stock options work
Stock options are a financial instrument (monetary contracts between parties) known as a derivative, which derives its value from an underlying security or rate. In the case of stock options, that asset is shares of a company’s stock.
Essentially, an option is a security sold from one investor to another. The option buyer pays a premium to the option writer (the person selling the derivative). In exchange for the payment, the buyer is given the right (option) to buy or sell a specified investment from or to the other party at a predetermined price at a specific time.
When a contract is written, it establishes the price, known as the strike (exercise) price, that the underlying stock must reach to be “in the money” (ITM). “In the money” (ITM) is a phrase that is used to refer to an option that has intrinsic value: a measure of what an asset is worth by performing an objective calculation and financial analysis, rather than looking at an asset’s current trading price. An option can also be out of the money (OTM) or at the money (ATM).
An option’s value is defined by the difference between the underlying stock price and the strike price:
- A call option is ITM if the market price is above the strike price;
- A put option is ITM if the market price is below the strike price.
Put and call options
A right to buy the option from the option writer is known as a call, and the option to sell a share is known as a put. The profitability of each option will depend on the option’s strike price and the underlying stock’s market price at the options’ expiration date.
A stock call option grants the buyer the right to buy stock. A call option will increase in value when the underlying stock price rises.
A stock put option grants the buyer the right to sell stock short. A put option will increase in value when the underlying stock price falls.
The expiration time of an options contract is the exact date and time when it is rendered null and void. An option must be exercised during a given period on or before the expiration date. If an investor decides not to exercise that right, the options contract expires and becomes invalid, losing the money they spent to buy it.
The expiration date for listed stock options in the United States is typically the third Friday of the contract month (the month when the contract expires). However, when that Friday falls on a holiday, the expiration date is on Thursday immediately before the third Friday.
Styles of options
There are two distinct styles of options: American and European:
- American options may be exercised at any time between the purchase and expiration date;
- European options (less common) can only be exercised on the expiration date.
Stock options’ key terminology
- Exercise – To exercise a stock option is to buy (in the case of a call) or sell (in the case of a put) the underlying asset at its strike price. Once exercised, the option disappears, and the underlying asset is delivered at the strike price;
- Expiration date – Options allow traders to bet on a stock rising or falling and enable them to choose the exact date when they expect the stock to rise or fall. That date is known as the expiration date. The expiration date is essential because it helps traders price the value of the call and the put, known as the time value, and applied in various option pricing models;
- Strike price – The strike price of an option is a fixed price at which the option owner can buy or sell the underlying security. It is the price at which a put or call option can be exercised. Accordingly, it is the price that a trader expects the stock to be above or below by the expiration date;
- Contract size – Contracts represent a specific number of underlying shares that a trader may want to buy. One options contract is equal to 100 shares of the underlying stock;
- Premium – The premium is the price you pay for an option. It is determined by taking the cost of the call and multiplying it by the number of contracts bought, then multiplying it by 100 (shares of the underlying stock in the contract).
Call Option example
Example: Let’s imagine an investor who speculates that the price of stock X will rise in two months. They purchase a call option contract for 100 shares of stock X and pay $2.15 for the option. This contract allows them to buy these shares for $50 each at any point during the next three months (before expiration). Fast-forward to the expiration date, stock X is now at $55 per share ($5 more than the strike price). This means the investor is “in the money.”
To determine the investor’s profit, subtract the strike price from the current price and add the premium paid to the difference. Finally, you would multiply that total by 100 (since the contract is for 100 shares) to come up with the total dollar profit. Therefore, if X is trading at $55, the strike price is $50, and the premium is $2.15, your profit is $2.85 per share. This call option contact was for 100 shares, so your total profit is $2.85 multiplied by 100, or $285.
An opposite scenario applies for a put option, where an investor profits if the underlying stock falls below the strike price by the expiration date.
Pros and cons of trading stock options
Trading options can be highly lucrative in the short term, but generally only when you have years of experience trading in the market. Options require close market observation and analysis, extreme risk tolerance, and market savvy. The potential of doubling or tripling your initial investment comes with the very real risk of losing it all.
- Options can deliver very high returns over a short period by implementing the power of leverage to turn a moderate sum of money into its value many times over;
- Useful option when limiting risk to a certain point. While options can allow you to earn a stock-like return while investing less money, they can be a way to modify your risk within certain bounds;
- Offer a wide range of strategic alternatives, making them a very flexible investment tool;
- Can be a lucrative investment strategy for experienced traders who know how to manage risk;
- There is an opportunity to multiply your earnings at a much higher rate. That is, if you’re right, you run the risk of a complete loss if you’re wrong;
- Options let you generate income reasonably fast. For example, stockholders can sell call options against their stock positions or write put options to generate revenue. Such strategies can be attractive and a moderately low-risk way to use options.
- On top of having the right investment thesis, it also has to be correct in the appropriate time period;
- Fluctuation is a daily occurrence with options, often experiencing more than 50 percent price moves, meaning your investment could decline in value quickly;
- Without a solid strategy, you can lose more than you invest in them;
- Options are short-term instruments whose price depends on the underlying stock’s price, so the option is a derivative of the stock. An unfavorable move in the stock price can affect the option value permanently;
- Options expire, and when they do, the opportunity to trade them is over; once expired, options are rendered worthless and invalid;
- It can be a risky endeavor, especially for beginner investors, if they haven’t done proper research and don’t have a sound strategy ready.
Understanding employee stock options (ESOs)
Employee stock options (ESOs) are a common way to attract potential employees and retain current ones. The incentive lies in the prospect of owning the company’s stock at a discounted rate compared to the open market.
Employee retention occurs through a technique called vesting. A vesting schedule is an incentive program instituted by the employer to give the employees the right to specific asset classes. It is used to encourage employees to remain with the company for longer.
A vesting schedule lets employees gain full ownership of employer-provided assets only over time. It can also allocate profits, equity, and stock options to employees. Employees surrender their unvested portion of securities if they leave before being 100% vested.
For instance, let’s assume an employee has been granted 10,000 shares with a four-year vesting schedule at 2,500 shares at the end of each year. This means you have to stay for at least one full year to exercise the first 2,500 shares and must remain to the end of the fourth year to be able to exercise all 10,000 shares. The employee will likely have to stay with the company for the total vesting period to receive the full grant.
Most importantly, ESOs can only be exercised once they are fully vested. What is more, the options will only have real value once they are exercised. The price of these options will be specified in your employment contract and will be stated as either the grant/strike/exercise price. No matter how the company does on the market, that price will stay the same.
There are various ways of exercising your options:
- Cash payment: you have 20,000 stock options with an exercise price of $1. To exercise all of your options, you would need to pay $20,000 (20,000 x $1). Once you exercise, you own all of that stock and are free to sell it. You may also want to hold on to the stocks hoping that the price increases even more;
- Cashless exercise: you can conduct an exercise-and-sell transaction. For this, you will have to buy your options and immediately sell them. However, rather than utilizing your own money to exercise, the brokerage handling the sale will effectively lend you the money, using the money made from the sale to cover what it costs you to buy the shares;
- Exercise-and-sell to cover transaction costs: by this strategy, you sell just enough shares to cover your purchase of the shares and hold the rest.
ESOs and taxes
It’s crucial to remember that by exercising your options you will be subject to taxes on your respective gains. The amount and kind of taxes you pay depend on the type of options you hold.
Incentive stock options don’t require the employee to pay taxes immediately upon exercising their options, as such they are generally considered more tax-advantaged than NSOs. Taxes need to be paid only once you sell your shares. If the shares are kept for a certain holding period (keep ISOs for at least one year after exercising and two years after your options were granted), they will qualify as capital gains instead of ordinary income, and are taxed at a much lower capital gains tax.
Non-qualified stock options are different from ISOs in that, regardless of whether you hold your stock options or sell them, you must pay taxes on the spread (the difference between the grant and exercise price) at your ordinary-income tax rate. What is more, the income is also subject to payroll taxes, including Social Security and Medicare. However, NSOs taxes are withheld at the time of exercise.
To sum up, as we’ve seen, options can be an elegant way to modify risk exposure and exponentially grow your initial investment, but there is certainly no fast money to be made here. Trading in options is a complex field that requires a lot of research and attention. Thus, as a first-time investor, try your hand at more rudimentary securities before diving into financial derivatives-like options.
What’s more, if you have received stock options as a result of your employment compensation package, it is essential you do your research to fully understand the contract lest you lose your opportunity for a big payout.
What are the type of stock options?
The two main types of stock options are call and put options. A call option is a bet that the underlying stock’s price will rise. In contrast, a put option is a bet that the underlying stock’s price will decline. Options are purchased as contracts, each consisting of 100 shares of the underlying stock.
What does it mean to exercise a stock option?
To exercise a stock option is to buy (in the case of a call) or sell (in the case of a put) the underlying asset at its strike price. In the case of ESOs, exercising stock options means choosing (not a requirement) to purchase shares of the company’s stock at the set price specified in your option grant. If you decide to buy shares, you own a piece of the company.
What are the benefits of trading options?
Because of the tremendous leveraging power of options, investors can acquire an option position similar to a stock position but at substantial cost savings. as a result, offering a higher percentage return. Moreover, options provide a wide array of strategic alternatives, making them an incredibly flexible financial tool.
What are the drawbacks of trading options?
Despite the promise of beefy gains, options are a notoriously risky investment due to their intricate nature. Options are a wide complex field, and a lot can go wrong. So unless you’re willing to dedicate a considerable amount of time learning how to use options correctly, you might find yourself having lost all the money you put in.
What to keep in mind with your ESOs?
Firstly, pay attention to the vesting period – the amount of time you must wait to gain the total stake of stock options – leave the company early, and risk losing a portion of your securities. Secondly, keep in mind the options expiration date, most frequently ten years from the option grant date.