What is a Stock Option?

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Definition:

A stock option is an agreement that grants the owner the right 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 speculate on whether a stock’s price will rise or fall. If you’re the options holder, a ‘put’ is a speculation that a stock will fall; a ‘call’ is a speculation 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. John doesn’t have to exercise his right to purchase the shares and could let the option expire and become worthless after December. 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 an unrealized profit of $20 per share (minus fees and commissions and any potential tax implications).

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

Some characteristics of 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. Note: Some complex option strategies are even riskier and you can lose more than just your initial investment.

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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 “privileges,” which were options sold over the counter to investors by specialized dealers.

In 1973, the options world changed forever, when the Chicago Board Options Exchange (CBOE) was founded. The CBOE was the first marketplace for trading listed options and is responsible for many of the innovations we see today in the options market.

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 a company, these options are used to incentivize and reward employees. They generally 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 sometimes includes 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 option writer (the contract’s seller).

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 contracts between buyers and sellers - with no direct ownership rights attached.

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. At least in theory, a stock would need to fall to zero for a stock owner to experience a total loss of their investment.

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

One key benefit of a stock option is the ability to speculate on a stock’s price. 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, as one example, buy a put option (a 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 maximum an investor may lose if they buy a put option is the initial premium they paid (plus any fees) — there are also no associated borrowing costs. However, the put option has an expiration date while the stock does not.

What are some important terms?

  • Call Option: A call option is a contract between two parties that grants the option holder the right to purchase stock at an agreed price and on or before an agreed date. The buyer has the right — but is not obligated — to exercise. Whereas, the seller of a call is obligated to sell shares of the underlying stock at the strike price of the call until the expiration date.
  • Put Option: A put option is a contract between two parties that grants the option holder the right 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. The seller of a put option has the obligation to buy the underlying stock at the strike price if the option is assigned until expiration.
  • Strike Price: The 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: The amount of an option’s premium that will decay (decrease) as an option gets closer to expiration.
  • Assignment: An option seller (writer) will receive an assignment notice when the buyer exercises their position, and will have to honor the terms of the option contract.
  • 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 employee stock 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 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. 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. Securities trading is offered through Robinhood Financial LLC.

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