stock-options

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 Financial Concepts

Circle of Competence

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The circle of competence describes a person’s natural competence in an area that matches their skills and abilities. Beyond this imaginary circle are skills and abilities that a person is naturally less competent at. The concept was popularised by Warren Buffett, who argued that investors should only invest in companies they know and understand. However, the circle of competence applies to any topic and indeed any individual.

What is a Moat

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Economic or market moats represent the long-term business defensibility. Or how long a business can retain its competitive advantage in the marketplace over the years. Warren Buffet who popularized the term “moat” referred to it as a share of mind, opposite to market share, as such it is the characteristic that all valuable brands have.

Buffet Indicator

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The Buffet Indicator is a measure of the total value of all publicly-traded stocks in a country divided by that country’s GDP. It’s a measure and ratio to evaluate whether a market is undervalued or overvalued. It’s one of Warren Buffet’s favorite measures as a warning that financial markets might be overvalued and riskier.

Venture Capital

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Venture capital is a form of investing skewed toward high-risk bets, that are likely to fail. Therefore venture capitalists look for higher returns. Indeed, venture capital is based on the power law, or the law for which a small number of bets will pay off big time for the larger numbers of low-return or investments that will go to zero. That is the whole premise of venture capital.

Foreign Direct Investment

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Foreign direct investment occurs when an individual or business purchases an interest of 10% or more in a company that operates in a different country. According to the International Monetary Fund (IMF), this percentage implies that the investor can influence or participate in the management of an enterprise. When the interest is less than 10%, on the other hand, the IMF simply defines it as a security that is part of a stock portfolio. Foreign direct investment (FDI), therefore, involves the purchase of an interest in a company by an entity that is located in another country. 

Micro-Investing

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Micro-investing is the process of investing small amounts of money regularly. The process of micro-investing involves small and sometimes irregular investments where the individual can set up recurring payments or invest a lump sum as cash becomes available.

Meme Investing

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Meme stocks are securities that go viral online and attract the attention of the younger generation of retail investors. Meme investing, therefore, is a bottom-up, community-driven approach to investing that positions itself as the antonym to Wall Street investing. Also, meme investing often looks at attractive opportunities with lower liquidity that might be easier to overtake, thus enabling wide speculation, as “meme investors” often look for disproportionate short-term returns.

Retail Investing

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Retail investing is the act of non-professional investors buying and selling securities for their own purposes. Retail investing has become popular with the rise of zero commissions digital platforms enabling anyone with small portfolio to trade.

Accredited Investor

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Accredited investors are individuals or entities deemed sophisticated enough to purchase securities that are not bound by the laws that protect normal investors. These may encompass venture capital, angel investments, private equity funds, hedge funds, real estate investment funds, and specialty investment funds such as those related to cryptocurrency. Accredited investors, therefore, are individuals or entities permitted to invest in securities that are complex, opaque, loosely regulated, or otherwise unregistered with a financial authority.

Startup Valuation

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Startup valuation describes a suite of methods used to value companies with little or no revenue. Therefore, startup valuation is the process of determining what a startup is worth. This value clarifies the company’s capacity to meet customer and investor expectations, achieve stated milestones, and use the new capital to grow.

Profit vs. Cash Flow

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Profit is the total income that a company generates from its operations. This includes money from sales, investments, and other income sources. In contrast, cash flow is the money that flows in and out of a company. This distinction is critical to understand as a profitable company might be short of cash and have liquidity crises.

Double-Entry

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Double-entry accounting is the foundation of modern financial accounting. It’s based on the accounting equation, where assets equal liabilities plus equity. That is the fundamental unit to build financial statements (balance sheet, income statement, and cash flow statement). The basic concept of double-entry is that a single transaction, to be recorded, will hit two accounts.

Balance Sheet

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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

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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

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

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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

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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

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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 Modeling

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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.

Business Valuation

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Business valuations involve a formal analysis of the key operational aspects of a business. A business valuation is an analysis used to determine the economic value of a business or company unit. It’s important to note that valuations are one part science and one part art. Analysts use professional judgment to consider the financial performance of a business with respect to local, national, or global economic conditions. They will also consider the total value of assets and liabilities, in addition to patented or proprietary technology.

Financial Ratio

financial-ratio-formulas

Financial Option

financial-options
A financial option is a contract, defined as a derivative drawing its value on a set of underlying variables (perhaps the volatility of the stock underlying the option). It comprises two parties (option writer and option buyer). This contract offers the right of the option holder to purchase the underlying asset at an agreed price.

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