What Is a Stock Option?
A stock option (also known as an equity option), gives an investor the right, but not the obligation, to buy or sell a stock at an agreed-upon price and date. There are two types of options: puts, which is a bet that a stock will fall, or calls, which is a bet that a stock will rise. Because it has shares of stock (or a stock index) as its underlying asset, stock options are a form of equity derivative and may be called equity options.
Employee stock options (ESOs) are a type of equity compensation given by companies to some employees or executives that effectively amount to call options. These differ from listed equity options on stocks that trade in the market, as they are restricted to a particular corporation issuing them to their own employees.
- Stock options give a trader the right, but not the obligation, to buy or sell shares of a certain stock at an agreed-upon price and date.
- Stock options are a common form of equity derivative.
- One equity options contract generally represents 100 shares of the underlying stock.
- There are two primary types of options contract: calls and puts.
- Employee stock options (ESOs) are when a company effectively grants call options to certain employees.
Understanding Stock Options
Options are a type of financial instrument known as a derivative—i.e., their worth is based on, or derived from, the value of an underlying security or asset. In the case of stock options, that asset is shares of a company's stock. Essentially, the option is a contract that creates an agreement between two parties to have the option to sell or buy the stock at some point in the future at a specified price, known as the strike price (exercise price).
Stock options come in two basic forms:
- Call options afford the holder the right, but not the obligation, to buy the asset at a stated price within a specific timeframe.
- Put options afford the holder the right, but not the obligation, to sell the asset at a stated price within a specific timeframe.
Therefore, if XYZ stock is trading at $100, a $120-strike call would become worthwhile to exercise (i.e., convert into shares at the strike price) only if the market price rises above $120. Or, the 80-strike put worthwhile if the shares drop below $80. At that point, both options would be said to be in-the-money (ITM), meaning that they have some intrinsic value (namely, the difference between the strike price and the market price). Otherwise, the options are out-of-the-money (OTM), and consist of extrinsic value (also known as time value). OTM options still have value since the underlying has some probability of moving into the money on or before the option expires. This probability is reflected in the option's price.
Equity options are derived from a single equity security. Investors and traders can use equity options to take a long or short position in a stock without actually buying or shorting the stock. This is advantageous because taking a position with options allows the investor/trader more leverage in that the amount of capital needed is much less than a similar outright long or short position on margin. Investors/traders can, therefore, profit more from a price movement in the underlying stock.
Exercising an option means using the option holder's right to convert the contract into shares at the strike price.
Stock Option Parameters
American vs. European Styles
There are two different styles of options: American and European. American options can be exercised at any time between the purchase and expiration date. European options, which are less common, can only be exercised on the expiration date.
Options contracts exist for only a certain period of time. This is known as the expiration date. Options listed with longer expiration dates will have more time value since there is a greater chance of an option becoming in-the-money the longer there is for the underlying stock to move around. Option expiration dates are set according to a fixed schedule (known as an options cycle) and typically range from daily or weekly expirations to monthly and up to one year or more.
The strike price determines whether an option should be exercised. It is the price that a trader expects the stock to be above or below by the expiration date.
As an example, if a trader is betting that International Business Machine Corp. (IBM) will rise in the future, they might buy a call for a specific month and a particular strike price. For example, a trader is betting that IBM's stock will rise above $150 by the middle of January. They may then buy a January $150 call.
Contracts represent a specific number of underlying shares that a trader may be looking to buy. One contract is equal to 100 shares of the underlying stock.
Using the previous example, a trader decides to buy 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 option to exercise or buy 500 shares of IBM’s stock at $150, regardless of the current stock price. If the stock is worth less than $150, the options will expire worthless, and the trader would lose the entire amount spent to buy the options, also known as the premium.
The premium is the price paid for an option, It is determined by taking the price of the call and multiplying it by the number 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. However, if a trader wanted to bet the stock would fall they would buy the puts.
The volatility of the underlying security is a key concept in options pricing theory. In general, the greater the volatility, the higher 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), among several others.
Options can be bought or sold depending on the strategy a trader is using. Continuing with the example above, if a trader thinks IBM shares are poised to rise, they can buy the call, or they can also choose to sell or write the put. In this case, the seller of the put would not pay a premium but would receive the premium. A seller of five IBM January $150 puts would receive $500.
Should the stock trade above $150, the option would expire worthless allowing the seller of the put to keep all of the premium. However, should the stock close below the strike price, the seller would have to buy the underlying stock at the strike price of $150. If that happens, it would create a loss of the premium and additional capital, since the trader now owns the stock at $150 per share, despite it trading at lower levels.
Another popular equity options technique is trading option spreads. Traders take combinations of long and short option positions, with different strike prices and expiration dates, for the purpose of extracting profit from the option premiums with minimal risk.
Example of Stock Options
In the example below, a trader believes Nvidia Corp’s (NVDA) stock is going to rise in the future to over $170. They decide to buy 10 January $170 calls which trade at a price of $16.10 per contract. It would result in the trader spending $16,100 to purchase the calls. However, for the trader to earn a profit, the stock would need to rise above the strike price and the cost of the calls, or $186.10. Should the stock not rise above $170, the options would expire worthless, and the trader would lose the entire premium.
Additionally, if the trader wants to bet that Nvidia will fall in the future, they could buy 10 January $120 Puts for $11.70 per contract. It would cost the trader a total of $11,700. For the trader to earn a profit the stock would need to fall below $108.30. Should the stock close above $120 the options would expire worthless, resulting in loss of the premium.
Employee Stock Options
Companies sometimes grant call options to certain employees as a form of equity compensation to incentivize good performance or reward seniority. Employee stock options (ESOs) effectively give an employee the right to buy the company’s stock at a specified price for a finite period of time. ESOs often have vesting schedules that limit the ability to exercise. If the stock's market price has risen once the vesting periods end, the employee can benefit greatly by exercising those options.
Employee stock options are not publicly-traded - they are issued exclusively by corporations to their employees. Upon ESO exercise, the company must issue new shares to that employee, which has a dilutive effect as it increases the overall number of shares outstanding. Investors should pay attention to the number of outstanding employee options that have been issued to understand their fully-dilutive potential.
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 specific date in the future. Often, large corporations will purchase stock options to hedge risk exposure to a given security. On the other hand, options also allow investors to speculate on the price of a stock, typically elevating their risk.
What Are the 2 Main Types of Stock Options?
When investors trade stock options, they can choose between 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, which are equal to 100 shares of the underlying stock.
How Do Stock Options Work?
Consider an investor who speculates that the price 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 price that the stock must exceed in order for the investor to make a profit. Fast-forward to the expiration date, where now, stock A has risen to $70. This call option would be worth $20 as stock A’s price is $20 higher than the strike price of $50. By contrast, an investor would profit from 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 (in the case of a call) or selling (in the case of a put) the underlying at its strike price. This is most often done before expiration when an option is deeply in the money with a delta close to 100, or at expiration if it is in the money at any amount. When exercised, the option disappears and the underlying asset is delivered (long or short, respectively) at the strike price. The trader can then choose to close out the position in the underlying at prevailing market prices, at a profit.
The Bottom Line
Options contracts are derivatives that give the holder the right to buy (in the case of a call) or sell (in 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 come in standard units of 100 shares per contract, and many are listed on exchanges where investors and traders can buy and sell them with relative ease. Options pricing is an important financial achievement, where volatility has been identified as a key component of options theory,
ESOs are a form of equity compensation granted by companies to their employees and executives. Like a regular call option, an ESO gives the holder the right to purchase the underlying asset—the company’s stock—at a specified price for a finite period of time. ESOs are not the only form of equity compensation, but they are among the most common.