A stock option is a contract between two parties, like a company and an employee, that gives the owner of the option the right, but not the obligation, to purchase or sell stocks at an agreed-upon price. Basically, if you own a stock option, you have the option to buy or sell the underlying stocks.
In this guide, we’ll go over:
- What Are Stocks?
- How Do Stock Options Work?
- What Are Stock Options Used For?
- Related Skills for Investing
What Are Stocks?
In order to understand what a stock option is, we need to know: What is a stock?
A stock is a type of tradable asset that represents a piece of ownership in a company. Essentially, when you buy a stock, or shares of a company, you are buying the future profits of that company: If the company does well, you make money, but if the company does poorly, you lose money.
There are typically two types of stocks: common stocks and preferred stocks. With certain stocks, you may earn the right to vote for the company’s leadership board, too. Stocks are typically bought and sold through stock exchanges or markets, such as the New York Stock Exchange (NYSE).
How Do Stock Options Work?
Stock options are typically purchased for a price, called a premium — you buy the rights associated with the option. A stock option gives an investor the right to purchase or sell stocks at a set price within a specific timeframe. Stock options typically include an expiration date — this means that the option must be used (the stocks must be bought or sold) by that date.
If you purchase an option, you are the owner of the option until it expires or until you exercise the option, by buying or selling the underlying stock associated with the option.
The stock option contract also comes with a specific set price, called a strike price, which can sometimes be higher or lower than the actual stock price itself. What this means is that if you have a stock option with a strike price of $50, but the stock itself is worth $60, you are making a profit — you’d pay $50 for something that can be sold for $60.
There are two main types of stock options: put options and call options.
- Put options give the owner of the option the right to sell the stock short, or for less than it is worth. The put option itself will increase in value if the underlying stock drops in price.
- Call options give the owner of the option the right to buy the underlying stock. Call options increase in value if the underlying stock increase in price.
The purchase of a “put option” gives the owner the right to sell the option’s underlying stock, while buying a “call option” gives the owner the right to buy the underlying stock. An easy way to remember the difference is:
- If you want to put the stock on someone else (or sell the stock), you buy a put option.
- If you want to call the stock towards yourself (or buy the stock), you buy a call option.
Employee Stock Options
Some employers may offer their employees stock option plans as part of a benefits package. An employee stock option plan (ESOP) is a form of equity compensation, giving each employee partial ownership in the company. As partial owners, employees have a stronger incentive to help ensure the success of their company — a successful company means better returns from their stock options.
Companies usually give their employees these options without any upfront cost, and some companies may even offer more shares the longer an employee stays with the company. However, cashing in on an ESOP can be tricky depending on the nature of the contract. Some ESOPs only allow retiring employees to cash out their profits, while other plans may let any employee leaving the company take their profits (and the cost of the shares they own) with them.
However, if you choose to exercise your ESOP and buy the underlying stock (if it is a call option), you own those stock shares regardless of when or how you leave the company.
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What Are Stock Options Used For?
There are many uses for stocks in general:
- For businesses, offering stocks to the public can help the company raise capital.
- For individuals, buying into stocks can help them see returns on their investments in the future.
A lot of different careers in finance involve buying or selling stocks and stock options. For example, an investment banker may utilize stock options as a way to incentivize investors to support a new company going through an initial public offering (IPO). The prospect of big profits due to low strike prices may even encourage investors to buy more than they otherwise would.
Additionally, private equity firms and hedge funds may use stocks and stock options to raise capital.
Any company could offer stock options, and even large, global organizations can offer employee stock option plans to their employees. Some smaller or newer companies may even utilize ESOPs to attract and retain employees.
>> MORE: Find out if finance is a good career path for you.
Related Skills for Investing
Understanding what stock options are and how to leverage them is important for many finance careers, such as investment banking. Some other skills investing professionals need include:
- Understanding debt capital markets
- Knowing how to value a business
- Analytical skills
- Ability to read stock charts
Ready to explore a career in finance? Learn the skills used by investment bankers every day with Forage’s Investment Banking Skills Passport.
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