Stock options: A primer on stock options

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Updated: 26 June 2020

Whether you receive stock options from your employer as part of a compensation package or purchase them from a broker, stock options are a unique financial product. While options are similar to futures, there is no obligation on the part of the stock option holder to actually purchase the stock. If the option holder decides not to purchase the stock and the option expires, there is no penalty to the option holder aside from the premium paid to purchase the stock options.

  • What are stock options
  • What are stock options used for
  • Stock options trading strategies
  • Stock option terminology

What are stock options – how do stock options work as compensation

Being offered stock options can be exciting. For the most part, a stock option is exactly that – the option to buy company stock. While stock options can become quite complicated, in their simplest form they are often offered as part of a compensation package by your employer. The potential value of owning stock in your company can vary greatly, so it is important to consider all the factors when evaluating stock options as part of a potential compensation package. It is also possible to purchase a selection of stock options from a broker.

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For the purposes of this article, we will be referring to both non-qualified employee stock options (ESOs) and broker-provided stock options as stock options. ESOs are the most common type of equity in a business that an employee is likely to receive. While private companies, such as startups, commonly offer ESOs as a form of compensation, some companies offer Restricted Stock Units (RSUs) instead.

While receiving stock options as compensation through your company is one method of acquiring stock options, they can also be purchased through a broker for a premium. Stock options can be used as a hedging tool to limit your losses if there is potential for your stock to fall, or for speculation where an increase in a given stock is possible. Traders can also purchase stock options to give themselves more time to decide whether purchasing a specific stock is in their best interests.

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Stock option terminology – specific terms you need to know

Like many financial investments, stock options have a number of terms that are unique to them. In order to make the best use of stock options, it is important to know these terms.

  • Strike price – Used interchangeably with exercise price, the strike price is the set dollar amount that you are permitted to buy or sell shares at
  • Expiration date – The expiration date is the date by which your stock options must be purchased, after this date the stock options will no longer be available to purchase
  • Exercising your options – Exercising your options is the act of actually purchasing the stock at the agreed-upon price laid out in your stock option certificate
  • Fair market value – Also known as market value, this is the current value of the stock rather than the price that you have option to purchase the stock at
  • Vesting schedule – Stock options obtained as part of a compensation package are often provided with a vesting schedule. This schedule allows you to obtain more options the longer you remain with the company. A typical vesting schedule might be four years, with a one year cliff. The one year cliff means that you do not receive any options until you have been with the company a full year. After that, you would receive 25% of your options for each following year.

Familiarity with the above terms will allow you to understand your stock options and how to use them more thoroughly.

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What are stock options used for? How to make the best use of your stock options

Aside from purchasing stock in the company you work for, stock options can be purchased from a broker. This is typically done for three reasons.

  • Originally devised as a tool for hedging, stock options can be used to limit risk when you already own stock in a company. If you are worried that the price of the stock may drop in the near future, purchasing an option to sell your stock near its current price can help you limit your losses. If the stock you own does not drop in price, you are under no obligation to sell and are merely out the cost of purchasing the option.
  • Another reason that stock options are frequently purchased is to reserve the opportunity to buy or sell a stock at the present price if you are currently undecided. Essentially, purchasing the stock option allows you to stop the clock while you determine the action you wish to take while maintaining access to the price at the time you purchased the option.
  • The final reason that stock options are typically purchased is as a tool for speculation. The price to purchase stock options varies based on a variety of factors, such as how much time is left before the expiration date and the fair market value compared to the strike price.

Rather than exercising the option, speculators often sell the stock options based on when their value increases.

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An example of how stock options work – publicly traded

You may simply be asking – how do stock options work? A stock options guide would not be complete without an example.

If you purchase your stock options from a broker, it is significantly different than being gifted or earning stock options as an employee for a company. When you purchase stock options from a broker, you are in control of how many stock options you purchase and related terms, such as the strike price and the expiration date.

When the company you work for offers you stock options as part of a compensation package, these terms are typically determined by them. Let's say you have worked for the company for five years, and you have accumulated 1,000 stock options over this time. At the time of your offer of employment, the offered stock options should include the details of the strike price and the expiration date.

If your options have an expiration date of six years after you began work with the company, and a price of £1, you would need to pay your employer £1,000 to exercise your options within the next year. If this payment is not made, the opportunity to purchase stock at this price evaporates.

If your employer is publicly traded at the time of your purchase, you can turn around and sell your stock, often for a profit. The fair market value for the stock may be £5, allowing you to profit by £4 per share.

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An example of how stock options work – privately owned

In the above example, if your company is not publicly traded when you exercise your stock options for £1, rather than receiving your stock you will receive a share certificate. You now hold a piece of the company, but it has no cash value. In many cases, you are unable to sell the stock you have accumulated while the company is privately owned.

Until the company is sold, issues a dividend or has an IPO, your share certificate is simply a promise. In the ideal world, you will not have to wait long for your company to become publicly traded or be acquired by another company or issue a dividend so that you can profit from the time you have invested in earning stock options.

Unfortunately, it is possible that when your company's stock becomes public, it may be worth less than what you paid for it. This is known as being underwater.

Receiving stock options can prove to be very beneficial for the employee while providing benefits for the employer as well. Stock options provide a way for the employee to share in the growth of the company, and to receive an additional benefit for the time and effort that they invest in helping the company to succeed. The company benefits, as well as employees, are incentivised to help the company grow. In many cases, stock options can also serve as a retention bonus for employees.

Stock options trading strategies

When trading stock options, there are a number of trading strategies that can be employed to either protect your assets or increase your investment value. Here are just of a few of the more popular trading strategies:

  • Long calls and puts

Some of the simplest types of options are called long calls and long puts. With a long call, the market must move about the strike price by more than the premium you paid to make a profit, while with a long put the market must move below the strike price by more than the premium. The cost of the premium also represents the maximum loss the trader can experience.

  • Married put

A married put is when a long put option is used to protect an owned asset from any potential short-term losses.

  • Short calls and puts

In this strategy, you take the writer side of the trade. This allows you to sell a call option on an asset that you own. If the market price of the asset fails to exceed the strike price of the option, then you profit by keeping the premium.

  • Straddles

With a straddle, you purchase both put and call options on the same market with the same expiry and strike price. In order to profit from this method, the market must be volatile. Whether it moves up or down you will generate a profit; if it is still you will simply lose your premium.

Many other trading strategies are available.

Conclusion

As with any type of investment, choosing the right broker can make a big difference with regards to your ability to profit from your investments. A broker comparison is a good first step to evaluating the fees, options available for purchase and other services that any brokers that you are considering using have available.

As seen above, stock options can be received as part of a compensation package if you work as an employee with either a private or public company. However, if your stock options are for a private company, you may need to wait any length of time in order for the options to have cash value, as the company must either be acquired, offer an IPO or issue dividends.

When it comes to trading stock options through a broker, there are numerous trading strategies that traders make use of. The three main reasons that traders do purchase stock options are to serve as a hedge against excessive potential loss, to buy themselves more time in order to make a decision, and as a tool for speculation – selling the actual stock option for profit rather than the stock itself.

After reviewing this introduction on stock options, some of the many purposes of stock options and their uses should be more clear. For a small investment, stock options can be used to provide protection for your existing investments, as a pure profit vehicle or in order to buy yourself more time to make a decision.