What is a Stock Option?

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Definition:

A stock option is an agreement that allows an investor to buy (in the case of a call) or sell (in the case of a put) a stock at a predetermined price on or before a specific date.

🤔 Understanding a stock option

Stock options can be used to help manage risk and to bet on whether a stock’s price will rise or fall. If you’re the options holder, a ‘put’ is a bet that a stock will fall; a ‘call’ is a bet that a stock will rise. Some companies use stock options as a way of incentivizing or rewarding their staff – commonly referred to as an Employee Stock Option (ESO) plan. Exchange-Traded Options (ETOs), meanwhile, are a standardized contract to buy or sell a set amount of a specific financial product at a set price on or before a set date. ETOs are traded on exchanges and guaranteed by clearinghouses. Keep in mind the clearinghouses ensure that the obligations of the contracts they clear are fulfilled and do not guarantee that investors will make a profit.

Example

Imagine that John recently joined an insurance company. Part of his compensation package is in stock options, which are performance-based. In February, he finds out he has met all his targets and is going to receive his stock-option bonus. The stock options have a strike price of $20 and an expiration date of December 31. This means he can buy shares in the company at $20, which is the same as buying on the stock market. John doesn’t have to exercise his right to purchase the shares and could let the option expire and become worthless after December –- This means he is no better or worse off. In November, John sees that the stock price of his company has risen to $40. As he only has one month to go until the option expires, he decides to exercise his option and purchases the stock at $20 – resulting in a profit of $20 per share (minus fees and commissions).

This example is for illustrative purposes only and does not reflect the performance of any investment. Investing always involves a certain amount of risk.

Takeaway

Stock options are like growing fruit…

You hope the seeds turn into something that can be picked at harvest. If the fruit is ruined and is inedible, then you lose the cost of the seeds. On the flip side, if the fruit is perfect and ripe, you have the option but not the obligation to pull the fruit off the tree.

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What is the history of stock options?

The first reported options trades occurred thousands of years ago in Ancient Greece, when olive press owners would use a rudimentary form of such instruments to manage price movements and risk.

The idea was adapted in the 19th century to the equity market. Russell Sage, a stock market investor and innovator at the time, played an instrumental role in the creation of the options market we see today, offering over-the-counter call and put options to investors.

What are different types of stock options?

There are several types of stock options, including:

  • Employee or incentive stock
  • Exchange-traded
  • Over the counter (OTC).

The mechanics of each are slightly different, but the basics are the same.

Employee or incentive stock options

Issued by the company, these options are used to incentivize and reward employees. They can’t be sold or transferred, and the worker has the right (but not the obligation) to exercise them and purchase shares in the company. Executive compensation will sometimes include an employee stock option plan.

Exchange-traded options

Traded like shares, investors can buy or sell ETOs on exchanges such as the Chicago Board Options Exchange. ETOs are also guaranteed by a clearinghouse, such as the Options Clearing Corporation. The options clearing house acts as an intermediary between the buyer and seller, to ensure that the transaction is settled correctly.

Over the counter stock options

Typically only available to institutional or wholesale clients, over-the-counter (OTC) stock options are set up to satisfy the needs of investors who want non-standard contract terms. OTC stock options do not clear through a clearing house; therefore, one risk of OTC options is bankruptcy and default of the issuer, which could mean the contract would be void.

What are Stocks vs. Stock Options?

Stocks are one of the most recognizable financial instruments in the world –- allowing an investor to own a stake in a company that is publicly traded. Options, on the other hand, are a contract between a buyer and seller - with no ownership rights attached.

Stocks allow investors the ability to enter or exit a position at will (otherwise known as liquidity). Options are tied to their expiration dates. As the option gets closer to that date, the value of the option can decline (something called “time decay”) and could potentially lead to a loss of the total investment. A stock would need to go to zero for total investment loss.

Stock options can provide the same exposure as stocks, with less initial outlay required. However, movements can be magnified (depending on the position) and could lead to significant losses. This is why options are not suitable for all investors and it is important to always look at your downside risk before entering any trade.

One key benefit of a stock option is the ability to speculate on a stock’s price declining. If an investor believes a stock price is going to fall, they can either short a stock (borrow shares they do not own and sell them on the market hoping to buy and repay the shares back when the price of the stock falls) or buy a put option (contract that allows the buyer to sell a stock at a predetermined price on or before a specific date). In this example, if the investor shorts the stock, then their maximum loss is unlimited, and they will need to borrow the stock (additional charges). On the other hand, the most an investor can lose on a put option is the initial premium the investor paid (plus any fees) — there are also no associated borrowing costs.

What are some important terms?

  • Call Option: A call option is a contract between two parties that allows the buyer to purchase stock at an agreed price and on or before an agreed date. The investor has the right — but is not obligated — to exercise.
  • Put Option: A put option is a contract between two parties that allows the buyer to sell stock at an agreed price on or before an agreed date. Like a call option, the buyer has the right but is not obligated.
  • Strike Price: The future price at which an option contract can be exercised. It is otherwise known as the exercise price.
  • Expiration Date: The date at which an option contract will expire.
  • Time Decay: As an option gets closer to expiration, its value will decay. This will become zero on the expiration.
  • Assignment: An option seller (writer) will receive an assignment notice when the buyer exercises their position.
  • Exercise: When a buyer exercises their options position, they will either take delivery of the stock or sell the stock (depending on whether it is a call or put option).
  • Cost of Carry: These are the associated costs with holding a position (i.e. interest rate costs, borrowing costs, and dividends).
  • Vesting: Otherwise known as the holding period, vesting dictates how long an employee must hold an option before they can exercise.
  • Receiving stock: The stock that will be delivered to the employee.
  • Reload Option: As the name suggests, the reload option occurs when a company provides the employee with new options upon exercise.

What are the potential risks of stock options?

Keep in mind, options trading has significant risk and isn’t appropriate for all investors — and certain complex options strategies carry even additional risk. To learn more about the risks associated with options trading, please review the options disclosure document entitled Characteristics and Risks of Standardized Options, available here or through https://www.theocc.com. Investors should absolutely consider their investment objectives and risks carefully before trading options. Supporting documentation for any claims, if applicable, will be furnished upon request.

Ready to start investing?
Sign up for Robinhood and get your first stock on us.Certain limitations apply

The free stock offer is available to new users only, subject to the terms and conditions at rbnhd.co/freestock. Free stock chosen randomly from the program’s inventory.

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