What are Stock Options?

stock optionsCompanies who needs money to expand their business can go to the bank for a loan or issue Stock Options.

Stock Options have two similar but slightly distinct meanings in everyday use. The first use is in the sense of employee stock options. And the second use is that stock options are traded on an exchange.

An employee stock option usually grants the employee the right to buy shares of the company at a discounted price. Companies frequently issue Stock Options to employees for a variety of reasons.

  • as an incentive for the employee to help improve the company’s profitability
  • to encourage them to stay with that company
  • to help improve the employee’s loyalty and commitment, and
  • to give them a sense (however small it might really be) of ownership.

Stock options became popular as incentives to employees of publicly traded companies. If you worked at IBM and IBM stock was at $90 a share, you might have been given stock options to buy 100 shares of the IBM stock at $95 a share by December. Since the stock was currently at $90 and you had an right to buy the stock at $95, the option is worthless.

The idea with employee stock options is that owning them does provide an incentive for you to help get the stock up to $100. If in December the stock is less than $95 you would never exercise your call and buy the stock–it would just expire worthless; but if the stock was at $95.01 or higher then you would exercise it and buy the stock at $95. Now you see why it is an “option”. For call options, if the stock price is below the “exercise” price then you don’t have to, nor should you, exercise it.

Exchange Traded Options

The stock markets have created exchanges that trade “Stock Options.” These stock options come in two types. There are call options, which are the right to buy shares of a stock at a certain price by a certain date. And there are put options, which are the right to sell shares of a stock at a certain price by a certain date.

In every day language, an option is defined as “the power or right of choosing”  There are two types of stock options —  calls and puts. Employees always gets call options.

Stock options are defined by 4 characteristics:

  • There is an underlying stock
  • There is an expiration date of the option
  • There is a strike price of the option
  • The option is either the right to buy or the right to sell (call and put, respectively)

The difference between calls and puts is the owner of a call option has the right to BUY a stock at a certain price. The owner of a put option has the right to SELL a stock at a certain price.

When you own stock options you have a choice if you want to exercise the stock options. You can buy the stock at that certain price by the expiration date. If the current market price of the stock is less than the strike price of the call option, then you would not exercise the call option and buy the stock.

Likewise, when you own a put option you can sell the stock at the strike price until option expiration. If the current market price of the stock is higher than the strike price of the put option, then you would not exercise the put option. If you choose to buy the stock, it is called “exercising” the stock options. If you choose not to buy the stock, the stock options are said to have “expired.”

We sell options in order to receive option premium. It give you better odds to close  options for profits.

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