What Are Stock Options?

I was recently asked this question by a visitor to my web site.

You may have seen the term “stock options” in the financial section while scanning the news. Or perhaps, you’ve encountered the term as an employee and were offered stock options in your company. So, what are stock options? Can these options be used to your advantage? Yes! There are two different types of stock options. Let me help you understand the difference.

Employee Stock Option (ESO)

An Employee Stock Option (ESO) is a type of non-cash compensation that is typically issued to management as part of an executive compensation package. Technically, an ESO is classified as a non-standardized option because it has several differences from an exchange traded option. The reason companies offer this type of compensation to management is because it provides management with incentive to run the business well. The stock of a well managed company with good growth potential is likely to rise, rewarding the management team.

Here are some differences between an ESO and an exchange traded option:

1) An ESO is may not be traded. That means that cannot be bought or sold in the open market on any kind of exchange. An ESO is strictly issued from the company to the employee.

2) The quantity of the ESO is determined by the company and is not standardized like an exchange traded option. The strike price or exercise price is usually the price of the company stock.

3) The duration of an ESO varies and it can be many years to expiration, unlike an exchange traded option that has a shorter life span to expiration.

Exchange Traded Option

An Exchange Traded Option is a standardized contract that is traded over the counter on a specific exchange. Standardized means that there is a standard set of rules governing the trading of that exchange traded option. These are the types of options that you will typically only have access to since they are traded on an exchange and available to the public.

1) Unlike an ESO, one standardized option contract represents one hundred shares. So if I bought one Apple (AAPL) option contract, I would actually control one hundred shares of that stock. If I decided to exercise that contract, then I would control one hundred shares of stock for every one option contract I exercised.

2) There are two types of standardized option contracts. You can be a buyer or a seller of an option and each gives you specific rights or obligations. To keep it simple in the example below, I will explain only the concept of buying the two types of options.

A call option gives you the right to buy the underlying asset (stock or future) at a set strike price. It is a right and not an obligation. You pay a premium or deposit for the option contract which gives you the right to own the stock at a set price on or before a set date. When you buy a call option, you expect the price of the underlying asset to go higher in order for the option contract to become profitable. What you have at risk is only the premium that you paid for the option contract. So, in the case of purchasing a home, you would put down a deposit to show the seller you were a serious buyer. If a few days later a tornado destroyed the house, you would lose only your deposit amount and not the full value of the home. I know there are probably ways to get your deposit back, but I wanted to give you a visual.

A put option gives you the right, but not the obligation, to sell the underlying asset (stock or future) at a set price on or before a set date. You pay a premium or deposit to own that right to sell. When you buy a put, you want the value of the underlying asset to go lower in order for you option to become profitable. Buying a put option is referred to as shorting the underlying asset. Many refer to put options as insurance. Recall the example above of the house destroyed by the tornado. If you were the seller of that house, then you would have paid an insurance premium to recoup the full value of the intact house and not the current, lower value of the destroyed house. 
The cost to you of rebuilding the house to its former state is the insurance premium you paid and nothing more.

3) An option contract has a determined expiration date on which the option will expire. Option buyers need to exercise (or sell) the stock option before this date. An option which has a long time to expiration is more expensive than an option with a shorter expiration date.

4) An option contract has an agreed price which is called the strike price. The strike is the price at which buyers of call options can buy the stock prior to expiration. It is also the price at which buyers of put options can sell the stock.

My Tips

1) A stock option is usually bought at a significantly lower price than the actual price of the underlying asset, so you don’t have to put up as much money to control the same amount of shares as if you were buying the underlying asset. This is one of the reasons why I use options than the underlying asset.

2) Because of the tremendous amount of leverage and the amount of shares you can control with options, you have to be extra careful. There are many components to the pricing of options. Keep in mind that over ninety percent of option contracts expire worthless so if you are thinking of putting your entire account in one option contract, then you might not have an account in the future.

3) The market trend will usually dictate which type of stock option to buy. If the market is in an uptrend, you would look to buy calls. Alternatively, if the market is in a downtrend, then you would look to buy puts.

Trading stock options may sound complicated, but it is much easier than it seems once you master some basic terminology and techniques. All the actual paperwork of the option contract is handled through brokers and stock exchanges. All you have to do is to consult with your financial advisor on whether it’s a good time to buy or to sell stock options. It is important that you understand how the system works, so that you manage your risk and don’t incur great losses.

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