How Do Stock Options Work?

Posted by Frank Gogol

If you are investing your money, your portfolio will include several asset classes. These may be stocks, bonds, ETFs, etc. Stock options are another asset class. In a well-balanced portfolio, stock options can offer you the opportunity to speculate, or to hedge your risks.

This sounds great, and you might well be asking: How do stock options work?

What Are Stock Options?

Stock options can be used in two different contexts. Firstly, experienced investors sometimes use stock options as a way to speculate, or to hedge their risks. Secondly, stock options are sometimes offered as equity compensation by a company to its employees.

In the investor context, stock options are contracts that allow you to either buy or sell a stock at a fixed, pre-determined price. This fixed amount is called the strike price. It is the set price that takes effect when you exercise your stock option. This contract is valid only for a certain time (which differs based on the terms in the contract). If you have a contract that allows you to buy a stock at a fixed price this is known as a “call”. If you have a contract that allows you to sell a stock at a fixed price this is known as a “put”. When the transaction occurs – when the stock is sold or bought – we say that the stock has been exercised.

Stock options work by exploiting the difference between the fixed price listed in the contract, and the ever-changing price of the stock as it trades on the stock exchange.

For example, say I have a call option to buy a stock at $10. The option is valid for the next two years. Now imagine two different scenarios:

Scenario 1. Over the next two years, the company I bought a stock option in, performs very poorly. Their stock price goes down. At the end of the two years, each stock in the company is worth $5. But the fixed price on my option is $10, so that is what I have to pay. I now have a stock that is worth $5, but I paid $10 for it. I will have made a loss.

Scenario 2. Over the next two years, the company I bought a stock option in, performs very well. Their stock price goes up. At the end of the two years, each stock in the company is worth $20. But the fixed price on my option is $10, so that is what I have to pay. I now have a stock that is worth $20, but I paid $10 for it. I will have made a profit.

You can now see the basic money-making strategy of a stock option. You want to have a call option when you think the market value of the stock will go above the fixed price listed on the stock option. Or you want to have a put option when you think the market value of the stock will go below the fixed price listed on the stock option.

Some companies also offer stock options in the company to their employees. These stock options are usually viewed as a perk of the job because it is given to you on top of your salary, or as a part of your benefits package.

In this case, you as the employee don’t have to buy the stock option. You are ‘given’ the contract as part of your compensation. So you are given the right to buy a specific number of stocks in the company at a fixed, pre-determined price. When you buy the stocks, it is known as the “exercise” of your option. When you exercise your stock option, you put the fixed amount of money in, and, after the waiting period is over, you own stocks. This waiting period is also called a vesting period.

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How Do Stock Options Work?

Now that you understand what stock options are, your next question should be: how do stock options work?

Stock options can be used speculatively by investors. This means you take a bet on whether the stock will be higher or lower than the strike price on the stock option contract. If you buy stock options speculatively, you are hoping to make a profit. In stock options, if the strike price is above the market price, we say that the option is “in the money”. When the market price is above the strike price, you are “out of the money”.

Stock options can also be used as a form of insurance – a way of hedging your bets. You want to buy a risky stock, but you also want to limit your losses. If you use a put option, you can limit your downside risk. In effect, you are betting against yourself. You believe that the stock will make you money, but you buy a put option just in case you are wrong.

Exercising and Selling Stock Options

When you exercise a stock option, you fulfil the contract inherent in the stock option. You buy or sell the stock at the strike price during the agreed-upon timeframe.

You can also sell your stock options. This means you find someone who wants to take your place in the contract. You find someone who is either willing to sell or buy the stock at the strike price so that you don’t have to do it.

If you were given stock as part of your employment, exercising your stock option would mean purchasing the stock in your employer company.

How to Exercise Stock Options

Once you are ready to exercise your options, you have several options.

Cash Payment – You come up with the cash to exercise the options. In other words, you buy the stock in a call option. For a put option, you would receive a cash payment for the strike price.

Cashless Exercise – A cashless exercise is most often used when referring to call options. You essentially fulfil the contract without putting down cash. For example, you could sell enough of your stock to cover the strike price and keep the remaining stocks.

Sell your stocks – Once your stocks have been exercised, you can sell them at the going market price. You are out of the market, and hence free from stock price volatility. And you won’t have to come up with upfront cash. However, keep in mind if you sell your stocks this is considered capital gain and may have tax implications.

How to Calculate What Your Stock Options Might Be Worth

Stock options are worth it if you are “in the money”. If you have a call option where the strike price is $20, and the stock is worth $25 on the stock market, then your option will be worth $5.

This can be harder to work out if the company you have options in is not yet listed on the stock market. This is much riskier, as you do not know whether the stock price is likely to rise above your strike price.

How Are Stock Options Taxed?

Some stock options are taxed at exercise. The difference between the stock market value and the strike price is subject to regular income tax for the year. When you eventually sell your shares, any additional gain is taxed as capital gains.

Other stock options are only taxed when you sell your shares. There are other restrictions on these options, but if you meet them, you’ll only owe capital gains tax when you eventually sell your stocks.

Conclusion

It’s not that hard to understand how do stock options work. Stock options are contracts that list a fixed buying or selling price for a stock. They work by using the difference between this fixed cost and the market value of the stock to make a profit or hedge risk. You can also be awarded stock options as an employment incentive.

Use the guidelines above to understand how do stock options work and make the best of yours!

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