Understanding Stock Options: Trading Basics and Practical Examples

What Is a Stock Option?

A stock option (also known as an equity option) gives an investor the right—but not the obligation—to buy or sell a stock at an agreed-upon price and date. There are two types of options: puts, which is a bet that a stock will fall, or calls, which is a bet that a stock will rise.

Because it has shares of stock (or a stock index) as its underlying asset, stock options are a form of equity derivative and may be called equity options.

Employee stock options (ESOs) are a type of equity compensation given by companies to some employees or executives that effectively amount to call options. These differ from listed equity options on stocks that trade in the market, as they are restricted to a particular corporation issuing them to their own employees.

How Stock Options Work

Options are a type of financial instrument known as a derivative. This means their worth is based on, or derived from, the value of an underlying security or asset. In the case of stock options, that asset is shares of a company’s stock. Not every stock will have a connected option chain.

An option is a contract between two parties, allowing them to sell or buy a stock at a specific price in the future. The price is known as the strike price or exercise price.

Stock options come in two basic forms:

• Call options afford the holder the right, but not the obligation, to buy the asset at a stated price within a specific time frame.
• Put options afford the holder the right, but not the obligation, to sell the asset at a stated price within a specific time frame.

Therefore, if XYZ stock is trading at $100, a $120-strike call would become worthwhile to exercise (i.e., convert into shares at the strike price) only if the market price rises above $120. Or, an $80-strike put would be worthwhile if the shares drop below $80. At that point, both options would be said to be in the money (ITM), meaning that they have some intrinsic value (namely, the difference between the strike price and the market price). Otherwise, the options are out of the money (OTM), and consist of extrinsic value (also known as time value). OTM options still have value since the underlying asset has some probability of moving into the money on or before the option expires. This probability is reflected in the option’s price.

Equity options are derived from equity securities, like stocks and exchange-traded funds (ETFs). Investors and traders can use equity options to take a long or short position in a stock without actually buying or shorting the stock. This is advantageous because taking a position with options allows the investor/trader more leverage in that the amount of capital needed is much less than a similar outright long or short position on margin. Investors and traders can, therefore, profit more from a price movement in the underlying stock.

Key Parameters of Stock Options

American vs. European Styles

There are two styles of options: American, which can be exercised anytime before expiration, and European, which can only be exercised on the expiration date.

Expiration Date

Options contracts have a set period, called the expiration date. Longer expiration dates mean more time value, as it increases the chance for the option to become profitable. Option expiration dates are set according to a fixed schedule (known as an options cycle) and typically range from daily or weekly expirations to monthly and up to one year or more.

Strike Price

The strike price determines whether an option should be exercised. It is the price that a trader expects the stock to be above or below by the expiration date.

As an example, if a trader is betting that International Business Machines Corp. (IBM) will rise in the future, they might buy a call for a specific month and a particular strike price. For example, a trader is betting that IBM’s stock will rise above $150 by the middle of January. They may then buy a January $150 call.

Contract Size

Contracts represent a specific number of underlying shares that a trader may be looking to buy. One contract is equal to 100 shares of the underlying stock.

Continuing the example, a trader buys five call contracts for January at $150. If the stock exceeds $150 at expiration, the trader can buy 500 shares at this price. If the stock is worth less than $150, the options will expire worthless, and the trader will lose the entire amount spent to buy the options, also known as the premium.

Premium

The premium is the price paid for an option. It is determined by taking the price of the call and multiplying it by the number of contracts bought, then multiplying it by 100.

In our example, if a trader buys five January IBM $150 calls for $1 per contract, the trader would spend $500. However, if a trader wanted to bet the stock would fall, they would buy the puts.

Strategies for Trading Stock Options

Stock options are traded on several exchanges like the CBOE, PHLX, and ISE.

Options can be bought or sold depending on the strategy a trader is using. Continuing with the example above, if a trader thinks IBM shares are poised to rise, they can buy the call, or they can also choose to sell or write the put. In this case, the seller of the put would not pay a premium but would receive the premium. A seller of five IBM January $150 puts would receive $500.

Should the stock trade above $150, the option would expire worthless, allowing the seller of the put to keep all of the premium. However, should the stock close below the strike price, the seller would have to buy the underlying stock at the strike price of $150. If that happens, it would create a loss of the premium and additional capital, since the trader now owns the stock at $150 per share, despite it trading at lower levels.

Another popular equity options technique is trading option spreads. Traders take combinations of long and short option positions, with different strike prices and expiration dates, for the purpose of extracting profit from the option premiums with minimal risk.

Real-Life Examples of Stock Options

In the example below, a trader believes NVIDIA Corp. (NVDA) stock is going to rise in the future to over $170. They decide to buy 10 January $170 calls, which trade at a price of $16.10 per contract. It would result in the trader spending $16,100 to purchase the calls. However, for the trader to earn a profit, the stock would need to rise above the strike price and the cost of the calls, or $186.10. Should the stock not rise above $170, the options would expire worthless, and the trader would lose the entire premium.

Additionally, if the trader wants to bet that NVIDIA will fall in the future, they could buy 10 January $120 puts for $11.70 per contract. It would cost the trader a total of $11,700. For the trader to earn a profit, the stock would need to fall below $108.30. Should the stock close above $120, the options would expire worthless, resulting in loss of the premium.

Understanding Employee Stock Options (ESOs)

Companies sometimes grant call options to certain employees as a form of equity compensation, to incentivize good performance or reward seniority. Employee stock options (ESOs) effectively give an employee the right to buy the company’s stock at a specified price for a finite period of time. ESOs often have vesting schedules that limit the ability to exercise. If the stock’s market price has risen once the vesting periods end, the employee can benefit greatly by exercising those options.

For example, if you begin to work at a startup, you might be given stock options for 12,000 shares of the startup’s stock as part of your compensation. These options aren’t given to you immediately; they vest over a designated period of time. Vesting means it becomes available to use. So after one year, you might be able to exercise 3,000 shares, then another 3,000 each year after that. By the end of four years, all 12,000 shares will be vested.

Employee stock options usually come with a “cliff” as well. This is the amount of time you must work with the company to receive your shares.

Employee stock options (ESOs) are not publicly traded but given by companies to employees. When exercised, new shares are issued, which can dilute the stock value. Investors should consider how many options are granted to evaluate potential dilution.

Calculating the Value of Your Stock Options

If the company you hold options for is publicly traded, the value of your stock options depends on the current value of the stock. Calculate how much it would be worth if you were buying or selling the number of shares that you have an option for at the public price. Then, calculate how much it would be worth to buy or sell the same number of shares at the price of your option. The difference between them is the value of your stock option.

If the company isn’t publicly traded, it becomes a little trickier. If the business has received a valuation that determines how much each share in it is worth, then that can give you a starting point to value your options. But that’s still a speculative number.

The number of shares (or options) out there also affects the value of yours. The more shares there are (for example, if most employees have been given stock options they can exercise), then the lower the value of each individual share in the business.

The value of your options also depends on the value of the stock itself. If you have an employee stock option to buy 20,000 shares at $2 a share, but the stock is currently trading at $1 a share, then your option currently has no value. If the price of the share rises to $3, however, then your stock options have a value of $20,000.

Exercising Your Stock Options

When you exercise your stock options, that is when you actually buy or sell them. An employee with stock options, for example, can only exercise those options after they have vested.

If you are buying stock from an option, you buy it at the option price, regardless of what the current price of the stock is. So if you are an employee with an option to buy 12,000 shares of stock at $1 a share, you will need to pay $12,000. At that point, you would own the shares outright. You would be able to sell them (if you think the price is going to go down) or keep them (if you think the price is going to go up).

If you don’t have the cash available, there are a few ways you can still exercise your stock options:

• Exercise-and-sell: Purchase your options through a brokerage and immediately sell them. The brokerage handling the sale will effectively let you use the money from the sale to cover the cost of buying the shares.
• Exercise-and-sell-to-cover: Purchase your shares through your brokerage, then sell just enough to cover the cost of the transaction. You keep the rest of the shares.

Tax Implications of Stock Options

If you exercise your stock options, you will need to pay taxes on any profit that you make. How your taxes are calculated depends on the type of option you have and how long you wait between exercising your option and selling your shares.

Taxes for Statutory Stock Options

Statutory stock options are granted through an employee stock purchase plan or an incentive stock option (ISO). For this type of option, you aren’t taxed when you are granted the option. In most cases, you will be taxed when you exercise the option. If that happens, your employer will report the income on your annual W-2 form.

If you are taxed after you exercise your option, it will be on the bargain element, which is the difference between the market value and the price you paid. For example, if the public price was $2 per share, and you exercised an option to buy 10,000 shares at $1 a share, you would pay taxes on the $10,000 difference between the two prices.

You would also have to pay capital gains tax whenever you sell your shares. If you hold the shares for less than a year after you sell them, they count as a short-term capital gain (or loss) and are taxed at your ordinary income rate. If you hold them for more than a year, they are taxed at the long-term capital gains rate (0%, 15%, or 20%, depending on your income and filing status).

Taxes for Non-statutory Stock Options

Non-statutory stock options aren’t granted through either an employee stock purchase plan or an ISO plan. In this case, you may have taxable income when you receive the option itself. For non-statutory stock options, the taxable income you are considered to have depends on how readily determined the fair market value of the option can be.

If the stock is publicly traded, the fair market value can be readily determined. In that case, the option is treated as taxable income at the time it is granted to you. The tax rate for that income will depend on your total income and tax bracket. When you later exercise the option, you do not have to pay tax on any amount of income from the option.

Most non-statutory stock options, though, don’t have a fair market value that can be readily determined. In that case, it is not treated as income until you exercise or transfer the option. Once you do that, you report the fair market value of the stock you receive (minus the amount you paid) as taxable income. This is usually taxed as a capital gain or loss.

Types of Stock Option Plans

There are different ways of structuring a stock option plan. These provide different levels of risk and incentive to both employers and employees.