What are Stock Options?

Most people are familiar with the term but exactly what are stock options?. This is important because stock options have become more common in recent years. They are often included in employee compensation packages. They are also a tool investors use to increase investment income.

An option is a type of derivative that creates the ability to buy or sell a security at a predetermined price.

Options are not securities themselves, but a play on the direction of the underlying security. The underlying security can be individual stocks, bonds, commodity futures contracts or even currencies. Let’s start with some definitions:

Call. This is the right to buy a stock at a specific price. There are also long- and short-calls. In a long call, the buyer pays a premium for the right to purchase the stock, and can exercise his option to buy when the stock price exceeds the call price plus the premium paid for it. In this way, the buyer can make money on a rising stock price without ever owning the stock. If it never reaches a level at which he can make a profit, he lets the call expire and loses only the premium he paid for it.

This is an option used if you believe that a security will rise. You would sell a (covered) call if you own the stock and don’t think it is going to rise in value much over a given time period. If you are right, you’ll hold on to your stock – and pocket the premium. If you plan on using this strategy, you would make sure to find out if you can write calls against your shares before you decide which stock to buy.

In a short call the buyer believes the security price will fall. You will have to sell the stock to the buyer of the call at the buyer’s option. This is a risky position to be in for the person making the short call. If the stock does drop, the gain will be limited to the amount of the premium; if the stock rises, the loss can be unlimited.

Put. This is the right to sell a security at a specific price. Just as with calls, there are also long- and short-puts. With a long put the buyer buys the right to sell the security at a fixed price with the anticipation that the security price will fall. If he figures out when to sell those shares, he’ll make a profit if the security falls below the exercise price plus the premium. If it doesn’t fall to that level he can just allow the put to expire and will only lose the premium paid for it.

A short put works when the buyer believes the security price will rise. If the security does rise above the exercise price, the buyer will make a profit equal to the amount of the premium. If the security doesn’t rise by more than the amount of the premium, the trader can lose up to the amount of the stock price.

Grant/strike price. This is the agreed upon price or security target price at which the option holder has agreed to trade the underlying security.

Premium. Essentially, this is the fee charged by the writer of the option.

Exercising, as in exercising an option. Exercising an option is simply completing the buy or sell by the option expiration date.

Expiration date. Options are usually taken for a specific period of time, which means they have an expiration date. After this, the options become worthless.

Confused? Unless you trade options regularly, it’s difficult to wrap your arms around the concepts completely. Options are not nearly as simple as holding the underlying securities themselves. But you can get a better understanding by studying the tutorials at online stock brokerage companies like Scottrade.

Stock options and employees

Stock options have become a popular form of compensation, especially for managers. They can be quite lucrative—or not—depending on what happens with the price of the underlying securities.

For employee stock options, the underlying security is most typically the stock of the employing company, though it can also be stock in an acquiring company. Employers will offer them to employees as an incentive to stay with the company and to motivate them to work harder so that higher stock prices are achieved and everyone benefits.

The options will include the right to be a certain number of shares of stock at a specified price during a limited time frame. The employer also typically establishes a vesting period of several years that restricts the employee from exercising the options. The vesting period is usually several years, which is one of the major ways that options keep employees from leaving the company.

The stock is usually offered at a discount, and when the options are exercised, the employee can sell all of the stock and realize an immediate gain, hold the stock for (hopefully) greater future gains, or sell some and hold the rest.

There are tax considerations with employee stock options that vary according to how the options are established. If your employer offers stock options you’re well advised to consult with a CPA for the proper tax treatment.

The risks of stock options

The risks of having stock options can be greater than actually holding the underlying stock or other securities. As we saw with short puts and short calls, you can lose 100% of the stock price and even more. As an investor, you wouldn’t want to have portfolio dominated by options.

The risk to employee stock options is generally lower since you don’t have to pay for the options up front. However, there can be a risk if you accepted less cash compensation in exchange for stock options. If the desired option prices aren’t reached, you could have given up substantial compensation in exchange for an investment scheme that never played out.

Have you ever traded stock options, or received them as compensation from an employer?