What Are Stock Options?

What Are Stock Options?

A stock option is a contract that gives the holder the right, but not an obligation, to buy or sell a stock at a specified price and time at any time before the option expires.

There are two primary types of stock options:

• Call options give you the right to buy shares of a stock at a specified price on or before expiration. Buy a call option if you think the stock's price will go up.
• Put options give you the right to sell shares of a stock at a specified price on or before expiration. Buy a put option if you think the stock's price will go down.

When you purchase an options contract, you pay a premium that's typically calculated as a price per share. Whether or not you decide to exercise your options—and either buy or sell the stock—you always pay the premium. Think of it as the cost of the contract.

Tip: Exercising your options means buying or selling stock shares as outlined in your contract. If you do nothing and the expiration date passes, your contract is void.

What Are Employee Stock Options?

Some companies offer employees stock options (ESOs) as a type of employee compensation. ESOs are basically call options: You get the option to purchase shares of stock at a designated price at some point in the future.

ESOs are usually granted on a vesting schedule, often with a "cliff" or period of time you must work before your options begin vesting. With cliff vesting, you might receive 25% of your shares per year over four years with a one-year cliff. In this scenario, you receive no shares during your first year of employment, then receive a quarter of your shares on or about your next four work anniversaries.

ESOs also have an exercise window during which you can choose to exercise your options. You have to exercise your options within this window, or risk losing your options altogether.

ESOs can be lucrative if the company's stock value rises during the course of your employment. Many employers also see options as an incentive for employees to work hard and help the company succeed.

ESOs typically fall into one of two categories:

Incentive Stock Options

Incentive stock options (ISOs) are often granted to key employees or investors. ISOs have special tax advantages: They aren't taxed when you exercise your options—only when you (eventually) sell your shares. If you hold your shares for more than two years from the date they're granted and one year from the exercise date, your proceeds are taxed as capital gains instead of regular income.

Non-Qualified Stock Options

Non-qualified stock options (NSOs) may be granted more widely, to all employees. NSOs don't have the same tax advantages as ISOs. When you exercise your options, you'll be taxed at your regular income tax rate on the difference between the strike price (the price at which the option can be exercised) and the stock's current value. If you sell your shares at a later time, you'll pay short- or long-term capital gains tax on any profits.

Learn more: What Is an Employee Stock Purchase Plan?

How Do Stock Options Work?

Here's a quick example of how stock options work.

Example: You purchase a call order for 100 shares of XYZ stock. Your strike price is $10, which means you can buy 100 shares for $10 each before the expiration date on your contract. You'll also pay a premium of $1 per share, or $100.

Possible Outcomes

Depending on what happens to the value of XYZ stock between now and your contract's expiration date, you may have one of two potential outcomes:

• The stock price goes up. Before your expiration date arrives, shares of XYZ are selling for $20. You can exercise your options and buy 100 shares at the strike price of $10 per share. If you close out your position (by selling the underlying stock), stand to make $1,000 ($10 per share x 100 shares), minus the $100 premium. You can also hold on to your shares of XYZ and hope the price continues to rise.
• The stock price stagnates or falls. If the price falls, you're out of the money. You don't want to buy XYZ stock at a $10 strike price if it's trading on the open market for less, so your contract expires worthless. You are out the $100 you paid for the premium.

Buying a Put

Put options give you the potential to make money when a stock price goes down. In a put, the contract's seller agrees to buy shares at the strike price on or before the expiration date.

Example: If the XYZ stock price dropped to $6, you (the contract's buyer) could close out your position by selling your contract for the difference between your strike price and the market price, minus the premium: ($10 - $6) x 100, or $400, minus $100 for the premium. Or, you could exercise your options, buy 100 shares for $600 market price and sell at the strike rate of $1,000. Either way, your net profit is about $300.

Buyers vs. Sellers

Every option has a buyer and a seller, sometimes referred to as the holder and the writer. You can sell calls or puts instead of buying them, though the rules for sellers are slightly different. As a seller, you collect the premium, which guarantees you make some money on the transaction. However, unlike buyers, sellers are obligated to sell or buy shares as promised if the buyer asks: The "option" is in the hands of the buyer.

Employee Stock Options

ESOs are essentially call options: You have the right to purchase shares in the company at a designated price, during a specified exercise window. But, ESOs aren't traded on the open market, so you generally don't have the option of selling your contract without exercising your options.

Learn more: When Is the Best Time to Buy and Sell Stocks?

Stocks vs. Stock Options

Stocks and stock options are related but different. Stocks represent an ownership stake in a company. Stock options derive their value from stocks, but owning stock options doesn't involve owning any actual stock—unless you exercise your options and purchase shares.

When you buy stock, you stand to profit when the stock price rises. With stock options, you can make money when the stock price increases or decreases. Purchasing stock options requires less money upfront than buying stocks. Though there's no guarantee that your stock options will be profitable, you can always walk away. When you do, you may lose 100% of your premium, but 0% beyond that. These factors make options more versatile than stocks.

However, mastering options can also be more difficult. Because you're agreeing to an expiration date, you're betting that a company's stock price will either increase or decrease by a given margin (strike price vs. market price) within a specific period of time. Adding a time element to the already complex business of predicting stock prices can make stock options much more complicated than trading stocks themselves.

Learn more: Can Anyone Invest in Stocks?

Pros and Cons of Stock Options

Trading options has its pros and cons, whether you're thinking about trying it on your own or trying to learn about ESOs you've received. Here are some upsides and downsides to consider:

How to Calculate the Value of Options

Calculating the value of your stock options is different depending on whether you have regular stock options or ESOs.

Regular Stock Options

Estimating the value of your stock options is simple when the underlying stock is publicly traded.

Find the current price of your stock and plug it into this formula:

When calculating your net profit, don't forget to account for the amount you paid in premiums and any transaction fees or commissions that apply.

Example: Suppose your underlying stock is trading at $200 and your strike price is $120. Each 100-share contract is worth $8,000: ($200 - $120) x 100 shares. For a put, convert a negative value to a positive and a positive value to a negative. In this example, the $80 difference between the current price and the strike price converts to -$80 and an $8,000 loss—a good reason to let the contract expire.

Employee Stock Options

Estimating the value of ESOs can be more difficult if the company's stock is not publicly traded. If you don't know your company's stock value, try contacting your company's human resources or finance department for advice.

Otherwise, the formula for estimating the value of your ESO is the same as for a regular call option.

Example: Say you have the option to buy 1,000 shares of company stock for $50 per share, and the current share value is $70. Your gain is roughly $20 per share, or $20,000.

What if You Don't Have Enough Cash to Buy the Stock?

You may be able to "exercise and sell," or buy and sell your shares in a single transaction. Alternatively, you may be able to "exercise and sell to cover," or sell only enough stock to cover the cost of buying shares at the strike price. This allows you to use your profits to buy (and hold) company stock.

What if You're Terminated Before Your Stock Options Vest?

Typically, you forfeit any unvested options when your employment is terminated, but check your employment contract and termination notice for specifics. Vested options may have a limited exercise window, often 90 days, following the end of your employment. Be sure to check so you don't miss the boat.

The Bottom Line

To make money with stock options, you need a fair level of expertise. You need to know whether a stock's price is headed up or down. You also have to pay attention to timing, to know when to exercise your options—or decide to close your position and move on. If you're interested in options, learn as much as possible about strategy and start small. Investing a small portion of your portfolio in options can help minimize risk as you're mastering your skills.

If you receive stock options from your employer, you may want to work with a financial advisor or tax advisor to help you map out your vesting schedule, track the company's stock value and devise a plan for exercising your options. ESOs can represent a significant portion of your employment compensation; it may be worth the extra effort to get the most out of them.