Stock Options In A Nutshell

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:

  1. 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.
  2. 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.

Strike price

Stock options come with an attached strike price, sometimes called an exercise price.

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.

Settlement dates

Options contracts have settlement or expiry dates for which there are two main styles:

  1. American-style – where option holders can exercise any time before the settlement date.
  2. 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.

Key takeaways:

  • 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.

Connected Business Concepts

Accounting Equation

The accounting equation is the fundamental equation that keeps together a balance sheet. Indeed, it states that assets always equal liability plus equity. The foundation of accounting is the double-entry system which assumes that a company balance sheet can be broken down in assets, and how they get sources (either though equity/capital or liability/debt).

Balance Sheet

The purpose of the balance sheet is to report how the resources to run the operations of the business were acquired. The Balance Sheet helps to assess the financial risk of a business and the simplest way to describe it is given by the accounting equation (assets = liability + equity).

Income Statement

The income statement, together with the balance sheet and the cash flow statement is among the key financial statements to understand how companies perform at fundamental level. The income statement shows the revenues and costs for a period and whether the company runs at profit or loss (also called P&L statement).

Cash Flow Statement

The cash flow statement is the third main financial statement, together with income statement and the balance sheet. It helps to assess the liquidity of an organization by showing the cash balances coming from operations, investing and financing. The cash flow statement can be prepared with two separate methods: direct or indirect.

Capital Structure

The capital structure shows how an organization financed its operations. Following the balance sheet structure, usually, assets of an organization can be built either by using equity or liability. Equity usually comprises endowment from shareholders and profit reserves. Where instead, liabilities can comprise either current (short-term debt) or non-current (long-term obligations).

Capital Expenditure

Capital expenditure or capital expense represents the money spent toward things that can be classified as fixed asset, with a longer term value. As such they will be recorded under non-current assets, on the balance sheet, and they will be amortized over the years. The reduced value on the balance sheet is expensed through the profit and loss.

Financial Statements

Financial statements help companies assess several aspects of the business, from profitability (income statement) to how assets are sourced (balance sheet), and cash inflows and outflows (cash flow statement). Financial statements are also mandatory to companies for tax purposes. They are also used by managers to assess the performance of the business.

Financial Structuring

In corporate finance, the financial structure is how corporations finance their assets (usually either through debt or equity). For the sake of reverse engineering businesses, we want to look at three critical elements to determine the model used to sustain its assets: cost structure, profitability, and cash flow generation.

Financial Modeling

Financial modeling involves the analysis of accounting, finance, and business data to predict future financial performance. Financial modeling is often used in valuation, which consists of estimating the value in dollar terms of a company based on several parameters. Some of the most common financial models comprise discounted cash flows, the M&A model, and the CCA model.

Revenue Modeling

Revenue modeling is a process of incorporating a sustainable financial model for revenue generation within a business model design. Revenue modeling can help to understand what options make more sense in creating a digital business from scratch; alternatively, it can help in analyzing existing digital businesses and reverse engineer them.

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