What Is a Stock Option?

What Is a Stock Option?

Let me explain what a stock option, also known as an equity option, really is. It gives you, as 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: puts, which bet that a stock will fall, and calls, which bet that a stock will rise.

Since these options have shares of stock or a stock index as their underlying asset, they're a form of equity derivative, and you might hear them called equity options.

Then there are employee stock options, or ESOs, which companies give to some employees or executives as equity compensation. These are basically call options, but they're different from the ones traded on exchanges because they're restricted to the issuing company and its employees.

Key Takeaways

Stock options give you the right, but not the obligation, to buy or sell a stock at a predetermined price before a set expiration date. You'll find two main types: calls that anticipate a price rise, and puts that speculate on a fall. These can be traded on exchanges for hedging or speculation, offering leverage. Employee stock options let employees buy company stock at a specific price after vesting. Options vary in style, expiration, strike price, and premium, which all affect their value and use in strategies.

How Stock Options Work

Options are derivatives, meaning their value comes from an underlying security or asset—in this case, shares of a company's stock. Not every stock has options available, though.

An option is a contract between two parties that lets you buy or sell a stock at a specific price, called the strike or exercise price, in the future.

Stock options come in two forms: call options give you the right to buy the asset at a stated price within a timeframe, and put options give you the right to sell it.

For example, if XYZ stock is at $100, a $120-strike call becomes worthwhile to exercise only if the price rises above $120. An $80-strike put pays off if it drops below $80. When that happens, they're in the money with intrinsic value; otherwise, they're out of the money but still have extrinsic or time value because there's a chance the stock moves favorably before expiration. That probability factors into the option's price.

Equity options let you take long or short positions in stocks without actually buying or shorting them, which gives more leverage since you need less capital than a direct position on margin. This way, you can profit more from price movements.

Key Parameters of Stock Options

Options have American style, exercisable anytime before expiration, or European style, only on the expiration date.

The expiration date is the set period for the contract; longer ones have more time value because there's more chance for profitability. Expirations follow a cycle, from daily or weekly to monthly or yearly.

The strike price is what you expect the stock to be above or below by expiration. For instance, if you're betting IBM will rise above $150 by mid-January, you might buy a January $150 call.

Contracts cover 100 shares each. So buying five January $150 calls means you could buy 500 shares at $150 if it exceeds that at expiration; if not, you lose the premium.

The premium is the option's price, calculated as the per-contract price times contracts times 100. If five IBM January $150 calls cost $1 each, that's $500 spent. Volatility in the underlying stock drives premiums higher, as greater swings mean higher chances of profitability.

Strategies for Trading Stock Options

You can trade stock options on exchanges like CBOE, PHLX, and ISE. Buy or sell depending on your strategy—if you think IBM will rise, buy a call or sell a put. Selling a put means you receive the premium but might have to buy the stock at the strike if it falls below.

For example, selling five IBM January $150 puts gets you $500; if it stays above $150, you keep it all, but if below, you buy at $150 and could lose more.

Another approach is trading spreads: combine long and short positions with different strikes and expirations to profit from premiums with minimal risk.

Real-Life Examples of Stock Options

Suppose you believe NVIDIA stock will rise over $170. You buy 10 January $170 calls at $16.10 each, costing $16,100. To profit, it needs to exceed $186.10 by expiration; otherwise, you lose the premium.

If betting on a fall below $120, buy 10 January $120 puts at $11.70, costing $11,700. Profit if it drops below $108.30; above $120, and it's worthless.

Understanding Employee Stock Options (ESOs)

Companies grant ESOs to employees as incentives, giving the right to buy stock at a set price for a limited time, often with vesting schedules. For example, you might get options for 12,000 shares vesting 3,000 per year over four years, with a cliff requiring you to stay a certain time.

ESOs aren't publicly traded; exercising them issues new shares, potentially diluting value. Options expire, sometimes years after grant or soon after leaving—check your contract.

To value them, if public, compare market price to option price times shares. For private companies, use recent valuations, but it's speculative. More outstanding shares lower each one's value. If your option is at $2 but stock is $1, it's worthless; at $3, a 20,000-share option is worth $20,000.

Exercising Your Stock Options

Exercising means buying or selling at the option price after vesting. For employee options at $1 per share for 12,000, pay $12,000 to own them, then hold or sell.

If cash-short, try exercise-and-sell: buy via brokerage and sell immediately, using proceeds to cover costs. Or exercise-and-sell-to-cover: sell just enough to pay for the buy, keeping the rest.

Tax Implications of Stock Options

Exercising triggers taxes on profits, varying by option type and holding period.

For statutory options like ISOs, no tax on grant; usually taxed on exercise via W-2 on the bargain element (market minus exercise price). Capital gains apply on sale: short-term at income rate if under a year, long-term at 0-20% if over.

Non-statutory: if fair market value determinable (public stock), taxed on grant; otherwise, on exercise or transfer as capital gain/loss.

Why Would You Buy an Option?

You buy options to bet on a stock's rise or fall by a date, or corporations use them to hedge. They allow speculation with elevated risk.

What Are the 2 Main Types of Stock Options?

Call options bet on price rises; put options on declines. Each contract equals 100 shares.

How Do Stock Options Work?

If you speculate stock A at $10 will rise, buy a $50-strike call. If it hits $70 by expiration, it's worth $20 profit per share. For puts, profit if it falls below strike.

What Is Exercising a Stock Option?

Exercising means converting to shares at strike: buy for calls, sell for puts, usually when deeply in the money or at expiration if profitable. The option vanishes, and you get the asset to close at market for profit.

The Bottom Line

Stock options let you buy or sell shares at a set price before expiration, with contracts for 100 shares traded on exchanges. Understand pricing, especially volatility's role, for smart trading. ESOs compensate employees by allowing purchases at fixed prices. Knowing this helps you make strategic decisions as an investor or employee.