Stock options give investors the right to buy or sell a stock at a future agreed-upon date. Startups usually leverage stock options to create a longer-term commitment from employees based on the gained value of the company, thus lowering the salary expenses.
Understanding stock options
Stock options are contracts giving the option holder the right to buy or sell an underlying asset at a predetermined date and price. To acquire this right, the option buyer pays a premium to the seller of the option contract – otherwise known as a writer.
Options can be purchased like most other asset classes in a standard brokerage account.
There are two types:
- Stock call options – where the option purchaser gains the right to buy a stock without being obligated to do so. Call options increase in value as the price of the underlying asset increases.
- Stock put options – where the option purchaser gains the right to short a stock. Put options increase in value as the price of the underlying asset decreases.
The strike price is the predetermined buying or selling price for the underlying asset if the option is exercised. Put differently, options are exercised when the holder purchases the underlying asset for a price specified in the options contract. If every option is exercised, the holder acquires shares in the underlying asset and ceases to hold options.
Options contracts have settlement or expiry dates for which there are two main styles:
- American-style – where option holders can exercise any time before the settlement date.
- European-style – where option holders can only exercise on the settlement date.
In general, options not exercised before the settlement date become worthless.
Benefits of stock options
Investors are attracted to stock options for various reasons.
Here are a few of them:
- Income generation – some investors choose to earn extra income by writing call options against shares they already own. This strategy is beneficial when the investor predicts share prices to remain flat or decline slightly.
- Value protection – investors also buy put options to protect against share depreciation. Put options lock in the sale price of a security for the life of the option contract – irrespective of how low the share price may go.
- Speculation – options can also be used as a lucrative speculation tool because they are offered at a fraction of the cost. This allows holders to profit from the movement of the underlying asset without having to trade the shares themselves. Consider a gold mining company with options selling for 5 cents and shares selling for 10 cents. An investor who buys $1000 worth of options makes a 100% return on investment after a five cent increase in price. However, the investor who purchases $1000 worth of 10 cent shares requires that the share price increases by 10 cents to generate the same 100% return.
- Stock options give investors the right to buy or sell an underlying asset at a future price and date. This right is acquired by the option purchaser paying a premium to an option writer.
- Stock options come in two forms. Call options increase in value as the value of the underlying asset increases. Put options are purchased by investors who want to short stocks, so their value increases as the value of the underlying asset decreases.
- Stock options are attractive to investors for several reasons. They can protect income during periods of share price stagnation and be used as a lucrative speculation tool. Put options can also protect against share price deprecation.
Read Next: Financial Options.
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