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Stock options refer to two very different things. The first is an agreement that can give you the option to buy or sell stock. The second is a form of equity compensation that an employer may offer prospective and current employees.
Buying and selling options contracts can be risky and should be cautiously approached. But experienced traders can use options in various ways, including limiting potential losses.
All kinds of investors can access stock options with some of the best online brokerages and investment platforms.
Here are the basics of trading stock options, hedging strategies, and the risks involved with options contracts.
A stock option is an agreement between two parties. When you purchase a stock option, you have the right — but not an obligation — to buy or sell a stock at a specific price within a certain period. If you're the option seller, you must fulfill the agreement based on the buyer's decision.
"Stock options allow you to benefit from a change in a company's stock in a heightened or leveraged manner," explains Yves-Marc Courtines, CFP and principal of Boundless Advice LLC. "The gain may be from an increase or decrease in the stock's price."
Several key terms are important to discussing and understanding how options work:
Different types of options contracts are traded and categorized in varying ways. The two main types of options are:
You can buy or sell either type of option.
There are also differences between US and European options. In the US, the options holder (aka the buyer) can exercise the option at any time before the expiration date. European options can only be exercised on the expiration date.
You can buy or sell a specific number of shares of an underlying asset at the strike price on or before the expiration date. You're not obligated to trade the underlying asset in the event that you only want to buy or sell in more favorable market conditions.
Stock options provide investors with significant leverage since options are traded at a lower price than buying the stock outright. Plus, you'll get a larger position in that stock. If used correctly, options trading is an effective way of generating income from fluctuating stock prices. Options contracts are commonly used with stocks but can also be used for other assets such as bonds, commodities, and currencies.
"If you want to dip your toe in, you could write a covered call," says Morrison. "It means you own the stock, and you write a call, meaning you sell a call."
For example, you own 500 shares of company XYZ, which trades at $80 a share, and you sell five call option contracts — each contract is for 100 shares. You collect $1.20 in premiums per share and receive $600.
The holder has the right to purchase the 500 shares from you for $85 a share (the strike price) during the next six weeks. They may let the option expire if the stock's price never exceeds $85. But, if it does, the holder can exercise the option, and you'll lose out on potential gains. In either case, you get to keep the $600.
Options exchanges are a crucial element of options trading. They are specialized marketplaces facilitating option trading and ensuring fair and regulated trading among buyers and sellers. Option exchanges assist in market liquidity and efficiency and help investors make more informed trades through the transparency of the exchange's publicly displayed order book.
Options exchanges are used by both individual investors and institutional investors like investment banks or hedge funds.
Some of the major options exchanges in the US include:
Stock options pricing is determined using the option's intrinsic and time values. Other factors that influence price are interest rates and volatility.
The intrinsic value is the difference between the stock price and the predetermined strike price to reflect the option's overall profitability. Time value represents the possibility that the stock price moves in your favor before its expiration date. Over time, the time value decays, and the option loses value as it expires.
More complex mathematical pricing models can also ensure an option's fair market value based on factors like interest rates, dividend yields, stock price, and volatility. One of the well-known pricing models is the Black Scholes model. However, this model does not take into account cash flow flexibility.
Stock options are often utilized as a hedging strategy to reduce risk and potential loss in your investment portfolio. Some hedging strategies using stock option include:
Investing always involves risk, and options trading can be much riskier than buying and holding a company's stock.
"You can lose all the money you put in when you buy a stock," says Theresa Morrison, advisor at BlockSpaces. "If you buy or sell an option and you don't know what you're doing, you could lose the money, your car, and your house."
For buyers, there's a chance that the value of the underlying stock moves in the wrong direction, and they'll have to let the contract expire. A similar risk of investing in stock options can occur with wrong timing, as there is a chance that the underlying stock does move in the right direction, but not before the contract expires.
Investors can also use options to limit their potential losses. But you might not want to buy or sell options until you understand what you're getting into.
Employee stock options are a type of employee equity compensation. Companies may offer options as part of a sign-on bonus or retention program.
To draw a comparison, Morrison says, "An employee stock option is always a call option because you have the right, but not the obligation, to buy the company's shares at a fixed price during a certain period of time."
Courtines points out that, unlike traded stock options, equity offers are granted rather than purchased. Still, there's some risk involved. "What you're giving up is a paycheck," says Courtines. "Instead, you're getting an option that could be worth more but that could also expire worthless."
You may also have to wait until an option vests before exercising it. For example, a portion of your option may vest each year during the first five years in a new job.
Companies can offer two types of stock options — incentive or non qualified.
Other common types of equity compensation also exist, but these aren't technically options.
Equity compensation programs are a popular way for companies to attract and retain employees. Here are a few suggestions and points to consider if you're offered or receive equity compensation:
Also, consider how the equity impacts your entire financial position. For example, you may want to immediately sell shares from RSUs and ESPSs and use the proceeds to diversify your portfolio. Otherwise, your income and a large portion of your portfolio may depend on a single company's success.
Do you need a special account to trade stock options? Chevron icon It indicates an expandable section or menu, or sometimes previous / next navigation options.
Not all brokerage accounts offer options trading, so you'll need to make sure that the brokerage account you open offers stock options as a feature. You may need to meet additional account requirements, like a higher minimum account balance or a premium subscription.
Can stock options be exercised at any time? Chevron icon It indicates an expandable section or menu, or sometimes previous / next navigation options.
It is possible to exercise stock options at any time, depending on the option style. For example, American options can be exercised any time before the expiration date. European options, on the other hand, can only be exercised at expiration.
What happens if options expire out-of-the-money? Chevron icon It indicates an expandable section or menu, or sometimes previous / next navigation options.
If options expire out-of-the-money, they essentially lose all value and are worthless. The buyer losses the premium paid for the option.
How can beginners learn to trade stock options? Chevron icon It indicates an expandable section or menu, or sometimes previous / next navigation options.
Learning stock options trading for beginners is best through educational resources like online courses, reference articles and guides, and attending workshops or webinars. To see a theoretical scenario play out, beginners can also practice using paper trading accounts.
Are stock options only available for stocks? Chevron icon It indicates an expandable section or menu, or sometimes previous / next navigation options.
Stock options specifically refer to options tied to stocks. However, options trading also applies to other assets, such as bonds, indexes, ETFs, commodities, and currencies.
Louis DeNicola is the president of LD Money Media LLC and an experienced writer who specializes in consumer credit, personal finance, and small-business finance. He is a Nav-certified credit and lending specialist, a multi-year attendee of an 18-hour advanced credit education seminar, and a volunteer tax preparer through the IRS's VITA program. Louis works with various publishers, credit bureaus, Fortune 500 financial services firms, and FinTech startups. In addition to Insider, you can find his work on Experian, FICO, Credit Karma, FICO, and Lending Tree. You can connect with Louis on LinkedIn or reach out to him directly at ladenicola@gmail.com.
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