What Is a Stock Option?
A stock option (also referred to as an equity option), gives an investor the correct, but not the duty, to purchase or sell a stock at an agreed-upon price and date. There are two varieties of options: puts, which is a bet that a stock will fall, or calls, which is a bet that a stock will rise.
Since it has shares of stock (or a stock index) as its underlying asset, stock options are a type of equity derivative and will be called equity options.
Worker stock options (ESOs) are a form of equity compensation given by firms to some employees or executives that effectively amount to call options. These differ from listed equity options on stocks that trade available in the market, as they’re restricted to a specific corporation issuing them to their very own employees.
Key Takeaways
- Stock options give a trader the correct, but not the duty, to purchase or sell shares of a certain stock at an agreed-upon price and date.
- Stock options are a standard type of equity derivative.
- One equity options contract generally represents 100 shares of the underlying stock.
- There are two primary varieties of options contracts: calls and puts.
- Worker stock options (ESOs) are when an organization effectively grants call options to certain employees as compensation.
Understanding Stock Options
Options are a form of financial instrument referred to as a derivative. This implies their price is predicated on, or derived from, the worth of an underlying security or asset. Within the case of stock options, that asset is shares of an organization’s stock. The choice is a contract that creates an agreement between two parties to have the choice to sell or buy the stock in some unspecified time in the future in the long run at a specified price. The value is referred to as the strike price or exercise price.
Stock options are available in two basic forms:
- Call options afford the holder the correct, but not the duty, to buy the asset at a stated price inside a selected timeframe.
- Put options afford the holder the correct, but not the duty, to sell the asset at a stated price inside a selected timeframe.
Due to this fact, if XYZ stock is trading at $100, a $120-strike call would develop into worthwhile to exercise (i.e., convert into shares on the strike price) provided that the market price rises above $120. Or, an $80-strike put could be worthwhile if the shares drop below $80. At that time, each options could be said to be in-the-money (ITM), meaning that they’ve some intrinsic value (namely, the difference between the strike price and the market price). Otherwise, the choices are out-of-the-money (OTM), and consist of extrinsic value (also referred to as time value). OTM options still have value for the reason that underlying asset has some probability of moving into the cash on or before the choice expires. This probability is reflected in the choice’s price.
Equity options are derived from a single equity security. Investors and traders can use equity options to take a protracted or short position in a stock without actually buying or shorting the stock. That is advantageous because taking a position with options allows the investor/trader more leverage in that the quantity of capital needed is way lower than an identical outright long or short position on margin. Investors and traders can, due to this fact, profit more from a price movement within the underlying stock.
Exercising an option means using the choice holder’s right to convert the contract into shares on the strike price.
Stock Option Parameters
American vs. European Styles
There are two different types of options: American and European. American options could be exercised at any time between the acquisition and expiration date. European options, that are less common, can only be exercised on the expiration date.
Expiration Date
Options contracts exist for less than a certain time frame. That is referred to as the expiration date. Options listed with longer expiration dates could have more time value since there’s a greater probability of an option becoming in-the-money the longer there’s for the underlying stock to maneuver around. Option expiration dates are set in line with a set schedule (referred to as an options cycle) and typically range from day by day or weekly expirations to monthly and up to at least one 12 months or more.
Strike Price
The strike price determines whether an option must be exercised. It’s the value that a trader expects the stock to be above or below by the expiration date.
For example, if a trader is betting that International Business Machine Corp. (IBM) will rise in the long run, they could buy a call for a selected month and a specific strike price. For instance, a trader is betting that IBM’s stock will rise above $150 by the center of January. They might then buy a January $150 call.
Contract Size
Contracts represent a selected variety of underlying shares that a trader could also be seeking to buy. One contract is the same as 100 shares of the underlying stock.
Using the previous example, a trader decides to purchase five call contracts. Now the trader would own five January $150 calls. If the stock rises above $150 by the expiration date, the trader would have the choice to exercise or buy 500 shares of IBM’s stock at $150, whatever the current stock price. If the stock is price lower than $150, the choices will expire worthless, and the trader would lose the whole amount spent to purchase the choices, also referred to as the premium.
Premium
The premium is the value paid for an option, It is decided by taking the value of the decision and multiplying it by the variety of contracts bought, then multiplying it by 100.
In our example, if a trader buys five January IBM $150 Calls for $1 per contract, the trader would spend $500. Nevertheless, if a trader desired to bet the stock would fall they’d buy the puts.
The volatility of the underlying security is a key concept in options pricing theory. Generally, the greater the volatility, the upper the premium required for all options listed on that security.
Trading Stock Options
Stock options are listed for trading on several exchanges, including the Chicago Board Options Exchange (CBOE), the Philadelphia Stock Exchange (PHLX), and the International Securities Exchange (ISE), amongst several others.
Options could be bought or sold depending on the strategy a trader is using. Continuing with the instance above, if a trader thinks IBM shares are poised to rise, they should buy the decision, or they may decide to sell or write the put. On this case, the vendor of the put wouldn’t pay a premium but would receive the premium. A seller of 5 IBM January $150 puts would receive $500.
Should the stock trade above $150, the choice would expire worthless allowing the vendor of the put to maintain all the premium. Nevertheless, should the stock close below the strike price, the vendor would need to buy the underlying stock on the strike price of $150. If that happens, it could create a lack of the premium and extra capital, for the reason that trader now owns the stock at $150 per share, despite it trading at lower levels.
One other popular equity options technique is trading option spreads. Traders take combos of long and short option positions, with different strike prices and expiration dates, for the aim of extracting make the most of the choice premiums with minimal risk.
Example of Stock Options
In the instance below, a trader believes Nvidia Corp’s (NVDA) stock goes to rise in the long run to over $170. They determine to purchase 10 January $170 calls which trade at a price of $16.10 per contract. It might end in the trader spending $16,100 to buy the calls. Nevertheless, for the trader to earn a profit, the stock would wish to rise above the strike price and the fee of the calls, or $186.10. Should the stock not rise above $170, the choices would expire worthless, and the trader would lose the whole premium.
Moreover, if the trader desires to bet that Nvidia will fall in the long run, they may buy 10 January $120 Puts for $11.70 per contract. It might cost the trader a complete of $11,700. For the trader to earn a profit the stock would wish to fall below $108.30. Should the stock close above $120 the choices would expire worthless, leading to lack of the premium.
Worker Stock Options
Corporations sometimes grant call options to certain employees as a type of equity compensation to incentivize good performance or reward seniority. Worker stock options (ESOs) effectively give an worker the correct to purchase the corporate’s stock at a specified price for a finite time frame. ESOs often have vesting schedules that limit the flexibility to exercise. If the stock’s market price has risen once the vesting periods end, the worker can profit greatly by exercising those options.
For instance, if you happen to begin to work at a startup, you is likely to be given stock options for 12,000 shares of the startup’s stock as a part of your compensation. These options aren’t given to you immediately; they vest over a delegated time frame. Vesting means it becomes available to make use of. So after one 12 months, you would possibly find a way to exercise 3,000 shares, then one other 3,000 every year after that. By the top of 4 years, all 12,000 shares can be vested.
Worker stock options often include a “cliff” as well. That is the period of time you have to work with the corporate to receive your shares. In case you get a brand new job before you reach the cliff, you lose all of your stock options. After that cliff, even if you happen to leave the corporate, your options will proceed to vest on schedule.
Options often include an expiration date, which is the last point at which you’ll exercise your option. This could possibly be a set variety of years after the choice is granted or a set variety of days after you allow the corporate. The small print of the expiration date must be in your contract.
Worker stock options usually are not publicly-traded: they’re granted exclusively by corporations to their employees. Upon ESO exercise, the corporate must grant recent shares to that worker, which has a dilutive effect because it increases the general variety of shares. Investors should concentrate to the variety of worker options which have been granted to know their fully-dilutive potential.
Find out how to Calculate the Value of Your Stock Options
If the corporate you hold options for is publicly traded, the worth of your stock options is determined by the present value of the stock. Calculate how much it could be price if you happen to were buying or selling the variety of shares you’ve an option for at the general public price. Then, calculate how much it could be price to purchase or sell the identical variety of share at the value of your option. The difference between them is the worth of your stock option.
If the corporate is not publicly traded, it becomes somewhat trickier. If the business has received a valuation that determines how much each share in it’s price, then can offer you a place to begin to value your options. But that is still a speculative number.
The variety of shares (or options) on the market also affects the worth of yours. The more shares there are (for instance, if most employees have been given stock options they will exercise), then the lower the worth of every individual share within the business.
The worth of your options also is determined by the worth of the stock itself. If you’ve an worker stock choice to buy 20,000 shares at $2 a share, however the stock is currently trading at $1 a share, then your option currently has no value. If the value of the share rises to $3, nonetheless, then your stock options have a worth of $20,000.
Find out how to Exercise Your Stock Options
Once you exercise your stock options, that’s while you actually buy or sell them. An worker with stock options, for instance, can only exercise those options after they’ve vested.
In case you are buying stock from an option, you purchase it at the choice price, no matter what the present price of the stock is. So if you happen to are an worker with an choice to buy 12,000 shares of stock at $1 a share, you will have to pay $12,000. At that time, you’d own the shares outright. You’ll find a way to sell them (if you happen to think the value goes to go down) or keep them (if you happen to think the value goes to go up).
In case you haven’t got the money available, there are just a few ways you may still exercise your stock options:
- Exercise-and-sell: Purchase your options through a brokerage and immediately sell them. The brokerage handling the sale will effectively let you utilize the cash from the sale to cover the fee of shopping for the shares.
- Exercise-and-sell-to-cover: Purchase your shares through your brokerage, then sell simply enough to cover the fee of the transaction. You retain the remainder of the shares.
Stock Options and Taxes
In case you exercise your stock options, you will have to pay taxes on any profit that you simply make. How your taxes are calculated is determined by the form of option you’ve and the way long you wait between exercising your option and selling your shares.
Taxes for Statutory Stock Options
Statutory stock options are granted through an worker stock purchase plan or an incentive stock option (ISO). For this kind of option, you are not taxed if you find yourself granted the choice. Normally, you can be taxed while you exercise the choice. If that happens, your employer will report the income in your annual W-2 form.
In case you are taxed after your exercise your option, it’s going to be on the cut price element, which is the difference between the market value and the value you paid. For instance, if the general public price was $2 per share, and also you exercised an choice to buy 10,000 shares at $1 a share, you’d pay taxes on the $10,000 difference between the 2 prices.
You’ll also need to pay capital gains tax at any time when you sell your shares. In case you hold the shares for lower than a 12 months after you sell them, they count as a short-term capital gain (or loss) and are taxed at your extraordinary income rate. In case you hold them for greater than a 12 months, they’re taxed on the long-term capital gains rate (0%, 15%, or 20% depending in your income and filing status).
Taxes for Nonstatutory Stock Options
Nonstatutory stock options aren’t granted through either an worker stock purchase plan or an ISO plan. On this case, you’ll have taxable income while you receive the choice itself. For nonstatutory stock options, the taxable income you might be considered to have is determined by how readily determined the fair market value of the choice could be.
If the stock is publicly traded, the fair market value could be readily determined. In that case, the choice is treated as taxable income on the time it’s granted to you. The tax rate for that income will rely on your total income and tax bracket. Once you later exercise the choice, you wouldn’t have to pay tax on any amount of income from the choice.
Most nonstatutory stock options, though, haven’t got a good market value that could be readily determined. In that case, it is just not treated as income until you exercise or transfer the choice. When you do this, you report the fair market value of the stock you receive (minus the quantity you paid) as taxable income. This is generally taxed as a capital gain or loss.
Varieties of Stock Option Plans
There are alternative ways of structuring a stock option plan. These provide different levels of risk and incentive to each employers and employees.
| Fixed Value Plan | Fixed Number Plan | Megagrant Plan | |
|---|---|---|---|
| Structure | Employees/executives receive options price a set value yearly | Employees/executives receive a set variety of options yearly | Employees/executives receive single, large grant of options |
| Advantages | Allow firms to maintain compensation consistent with competitors | Strongly links pay and performance | Strongly links pay and performance |
| Minimizes risk that worker will leave for higher compensation elsewhere | Creates an incentive to grow the corporate and increase stock value | High compensation that pulls top employees | |
| Drawbacks | Low link between pay and performance | Don’t protect future pay from changes in stock value prices | Significant decrease in value can remove incentive to spice up stock price or remain at the corporate |
| Minimal incentive to employees/executives | Lower pay during times of market turmoil | Dangerous for firms which can be susceptible to market volatility |
Why Would You Buy an Option?
Essentially, a stock option allows an investor to bet on the rise or fall of a given stock by a selected date in the long run. Often, large corporations will purchase stock options to hedge risk exposure to a given security. Then again, options also allow investors to take a position on the value of a stock, typically elevating their risk.
What Are the Two Fundamental Varieties of Stock Options?
When investors trade stock options, they will choose from a call option or a put option. In a call option, the investor speculates that the underlying stock’s price will rise. A put option takes a bearish position, where the investor bets that the underlying stock’s price will decline. Options are purchased as contracts, that are equal to 100 shares of the underlying stock.
How Do Stock Options Work?
Consider an investor who speculates that the value of stock A will rise in three months. Currently, stock A is valued at $10. The investor then buys a call option with a $50 strike price, which is the value that the stock must exceed to ensure that the investor to make a profit. Fast-forward to the expiration date, where now, stock A has risen to $70. This call option could be price $20 as stock A’s price is $20 higher than the strike price of $50. Against this, an investor would make the most of a put option if the underlying stock were to fall below his strike price by the expiration date.
What Is Exercising a Stock Option?
To exercise a stock option involves buying (within the case of a call) or selling (within the case of a put) the underlying at its strike price. That is most frequently done before expiration when an option is deeply in the cash with a delta near 100, or at expiration whether it is in the cash at any amount. When exercised, the choice disappears and the underlying asset is delivered (long or short, respectively) on the strike price. The trader can then decide to close out the position within the underlying at prevailing market prices, at a profit.
The Bottom Line
Options contracts are derivatives that give the holder the correct to purchase (within the case of a call) or sell (within the case of a put) a quantity of the underlying security at a specified price (the strike price) before the contract expires. Options on stocks are available in standard units of 100 shares per contract, and plenty of are listed on exchanges where investors and traders should buy and sell them with relative ease. Options pricing is a crucial financial achievement, where volatility has been identified as a key component of options theory,
ESOs are a type of equity compensation granted by firms to their employees and executives. Like an everyday call option, an ESO gives the holder the correct to buy the underlying asset—the corporate’s stock—at a specified price for a finite time frame. ESOs usually are not the one type of equity compensation, but they’re amongst probably the most common.