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Stock option: definition and overview

  • A stock option is a contract that gives you the right to buy or sell a stock at a certain price in the future.
  • There are low and high risk ways to trade options.
  • Employee stock options are a popular way for startups and public companies to attract and retain employees.
  • Visit Insider’s Investment Reference Library for more stories.

Stock options can mean two very different things. The first is a deal that can give you the option to buy or sell stocks. The second is a form of stock compensation that an employer can offer to potential and current employees.

Here is what you need to know about stock options.

What are stock options?

A stock option is an agreement between two parties. When you buy a stock option, you have the right, but not the obligation, to buy or sell a stock at a specific price within a certain period of time. If you are the seller of the option, you are required to complete the agreement depending on the buyer’s decision.

“Stock options allow you to profit from a variation in a company’s shares in an increased or leveraged way,” explains Yves-Marc Courtines, a financial planner and director of Boundless Advice LLC. “The gain can come from an increase or decrease in the share price.”

Several key terms are important for discussing and understanding how options work:

  • Holders and authors: The option holder buys the option and the option seller sells the option.
  • Exercise of an option: The holder exercises an option when he decides to buy or sell the share.
  • Expiration date: The end of the potential buy or sell period.
  • Premiums: The holder pays the subscriber a non-refundable premium for the option. Its value may depend on the expiration date and the expected volatility of the underlying stock.
  • Exercise or exercise price: The price at which the holder can buy or sell the stock.

American style options allow the option holder (the buyer) to exercise the option at any time prior to the expiration date. On the other hand, you can only exercise the European type options on the expiration date.

Call options versus put options

There are also two types of options: put options and call options.

  • A purchase option means that the holder can buy the stock at a specific price during a specific period.
  • A put option means that the holder can sell the stock at a specific price during a specific period.

You can buy or sell either type of option.

Is the purchase of stock options risky?

Investing always comes with risk, and options trading can be much riskier than buying and holding shares in a company.

“You can lose all the money you invest when you buy a stock,” says Theresa Morrison, founding partner of Beckett Collective. “If you buy or sell an option and you don’t know what you are doing, you could lose the money, your car and your house.”

Investors can also use options to limit their potential losses. But you may not want to buy or sell options until you understand what you are getting into.

An example of how stock options work

“If you want to get started, you can make a covered call,” says Morrison. “It means you own the stock and you write a call, which means you sell a call.”

For example, you own 500 shares of XYZ Company, which trades at $ 80 a share, and you sell five call option contracts – each contract is for 100 shares. You collect $ 1.20 in bonuses per share and receive $ 600.

The holder has the right to buy all 500 shares from you for $ 85 per share (the strike price) over the next six weeks.

The holder can let the option expire if the share price never exceeds $ 85. But, if it does, the holder can exercise the option and you will lose potential winnings. Either way, you keep the $ 600.

What are employee stock options?

Employee stock options are a type of employee stock compensation. Companies may offer options as part of a login bonus or loyalty program.

To make a comparison, says Morrison, “An employee stock option is always a call option because you have the right, but not the obligation, to buy the company’s stock at. a fixed price for a certain period “.

Courtines points out that unlike traded stock options, stock offers are granted rather than purchased. Still, there is some risk. “What you’re giving up is a paycheck,” says Courtines. “Instead, you get an option that might be worth more, but it might also expire worthless.”

You may also have to wait for an option to vest before you can exercise it. For example, part of your option may be earned each year during the first five years in a new job.

Common types of employee stock compensation

Companies can offer two types of stock options – incentive or unskilled.

  • Incentive Stock Options (ISO): An ISO can offer tax advantages because your profits could be subject to the capital gains tax rate. But they can also trigger the Alternative Minimum Tax (AMT).
  • Unqualified Stock Options (NSO): Do not benefit from special tax treatment. Your employer can automatically withhold income taxes and payroll taxes. Plus, you’ll pay regular income taxes on the difference between the current fair market value and your strike price.

There are other common types of equity compensation as well, but technically they are not options.

  • Restricted share units (RSUs): Companies may offer RSUs that you will receive based on a vesting schedule or to meet certain goals. “RSUs are more like a cash bonus,” explains Courtines, “and they have become the dominant form of incentive pay. ”
  • Employee share purchase plans (ESPP): The company allows you to buy its shares at a reduced price, often 5 to 15%.

What to ask if you are offered or if you have stock compensation

Equity compensation programs are a popular way for companies to attract and retain employees. Here are some suggestions and things to consider if you are offered or received stock compensation:

  • If you are receiving ISOs, Morrison suggests working with a professional to create an exercise strategy and five-year plan to account for potential tax implications.
  • When working in a private company, you may want to hire a financial advisor who can help you determine the value of the options or equity available to you.
  • If you receive RSUs at a private company, ask if they are limited by a liquidation event, such as an IPO or merger.
  • Make sure you accept options or stock grants – it’s not always automatic.
  • You may need to actively exercise your options, or they may expire.

Also consider the impact of equity on your overall financial situation. For example, you might want to immediately sell shares of RSU and ESPS and use the proceeds to diversify your portfolio. Otherwise, your income and a large part of your portfolio may depend on the success of a single business.

The financial report

Buying and selling options contracts can be risky and should be approached with caution. But there are a number of ways that experienced traders can use options, including limiting their potential losses.

Employee stock options are completely different from options trading, but they can also be complicated. While you don’t risk losing money, there is a potential opportunity cost to accepting options rather than cash compensation. You will also want to carefully consider the tax implications of exercising your options.

Margarita W. Wilson

The author Margarita W. Wilson