Last Updated: January 12, 2023
Have you ever wondered, “what are stock options?” Understanding this method of stock trading is essential to any investor who’s looking to make the most of the public market. Fortunately, they’re pretty easy to understand. Here are a few things you need to know to get the most value out of them.
What Are Stock Options?
Stock options are one of the three categories of financial instruments, with stocks and bonds being the other two. You can look at stock options as a non-obligatory contract between a buyer and a writer (seller). They allow you to buy a set number of stocks at a given time and price in the future. We should note that each standard options contract allows the purchase/sale of 100 shares of the underlying stock. Since it’s non-obligatory, owning a stock option doesn’t obligate you to actually perform any transactions — you just have that option.
How Do Stock Options Work?
To explain how stock options work, let’s look at an example. Let’s say you purchase a call option for $5 today, which lasts until a particular date in the future. Owning that stock option means that you can buy stock for a previously agreed price, e.g., $100, anytime until the end date. However, this is the American way of doing it. The European way of options trading gives a specific date, and you can only exercise it on that day. So, if you exercise the call and buy the stock for $100 when its current market price is $150, you get a profit of $45, subtracting the option price.
This way, you’re negating the risk of paying the current market price for a share that you think will rise in the future. You’re essentially paying $5 and getting a profit of $45, whereas if you bought the stock for $100 without an options contract, you’d risk $100 instead of $5.
Types of Stock Options
The first types of stock options we’ll be looking at are called Incentive Stock Options (ISO) and Non-Qualified Stock Options (NSO). In the USA, each of these is considered an employee stock option because they’re issued to employees by the company. Additionally, depending on if you’re buying or selling, there are calls and puts.
ISO and NSO
Incentive stock options (ISO) are a subtype of options offered only to employees as compensation for their work. ISOs can be exercised while you’re employed or within 90 days after leaving the company, and they’ll be transformed into NSO if any date extension occurs. These options are taxed after the holder sells the trading stocks.
Non-qualified stock options (NSO) are the second type of stock options, and companies give them to outsiders as well as employees. Since NSOs don’t require employment, their expiry date can be extended beyond 90 days. They have less favorable tax benefits than ISOs and are taxed after exercising. The taxed sum is the difference between the exercising price of the stock and its fair market value (FMV).
Call vs put options
Call options are the options you use to buy stock for a specific price known as the strike price between a certain period of time. You can, but aren’t obligated to, exercise the call on a certain date (European style) or until a certain date (American style). As an investor, you do this to make a profit at low risk by buying a rising stock at a lower price. On the other hand, you don’t have to exercise it if the stock price drops.
Put options are another method of option trading. They function similarly to call options, but with a put option, you sell the stock at a specific price and during a designated time frame. You usually do this to avoid any potential loss if you think the price of the stock you own will drop. In contrast, if the price surges, you’re not obligated to sell it, and you get to keep the stock.
Naked call and naked put
It’s also possible to sell trade options themselves without having underlying securities in case of calls or having short positions on them in case of puts. The investors obligate themselves to buy or sell stocks by specific dates, which may force them to trade at a loss.
These methods of trading options are also called uncovered puts and calls. In essence, they function the same as regular put and call strategies but they’re meant to secure a premium on an underlying security price change. The risks of these strategies are much greater and potential profits are lower, so they’re not recommended for beginners.
How to Trade Stock Options?
Since we now understand what puts and calls are, let’s move on to the trading process. Understanding the process will make it easier for you to earn a profit or prevent a loss. It’s important that you choose a top-notch trading platform for this, or you can do it yourself through direct access trading to save on commissions. Follow these steps if you want to effectively trade stock options:
Selecting a broker
The first step when trading options is selecting a well-rounded brokerage platform that will meet your needs. Most of them will allow you to trade your options, but some don’t offer that service — so do your research. If you need help, you can check out our list of best online brokers for beginners and pick the one that works for you.
Opening a demo account
It’s never a good idea to go blindly into trading of any kind, let alone securities. So, if you want to trade productively, start by opening a demo account. Most brokers offer it, so you shouldn’t have any trouble with that. Additionally, opening multiple accounts across many platforms will help you decide which one suits your needs for trading options the best.
Opening an account and funding it
The next step is checking if they have any particular account types and the initial deposit requirements. After that, you’re ready to create an account and fund it. You can fund it by depositing a margin and, if needed, an initial deposit. Not all of them require you to make an initial deposit; it depends on the broker. With this completed, you’re ready for options trading.
What Is the Difference Between Stocks and Stock Options?
While stocks and stock options may sound similar, they have quite a few differences. Owning stocks gives you partial ownership in the company you have bought the stock from, and you’re eligible for a dividend. Another crucial thing is that you buy or sell a stock at the current market price and then sell it when it peaks your target price.
In contrast, a stock option doesn’t give any ownership — it’s a contract that gives you the right to buy or sell stocks at a particular price and time span. By buying a stock option, you’re avoiding the risks associated with stock trading because your initial investment is comparatively low.
Finally, if you want to understand stock options a bit better, you can look at them as derivatives. A derivative gets its value from fluctuations in the underlying asset. So, what are stock options? Let’s sum up what we’ve learned.
– An option is a contract that gives its owner the right to buy or sell stocks at a specific price in the future until a certain date.
– To trade options, you need to know that there are two trading styles — the American and the European style. The former lets you buy or sell the stock from the day you bought the option until its expiration date, and the latter allows you to buy or sell the stock on a specific day.
– Options are a kind of financial instrument known as derivatives, and they usually derive their price from the underlying asset.
– Other important types include call and put options. A call lets you buy a stock at a specific price and date in the future, and a put lets you sell a stock at a particular price and date in the future.
– The key difference between stocks and stock options is that stocks give ownership in a company and stock options just give an investor the right to buy or sell stocks for a strike price in a specific time frame.
In conclusion, if you were able to answer the question “what are stock options?” and how to properly exercise them, you’re ready to start trading them.
The volatility of the market favors stock options since you can earn a huge profit by risking a small amount of money. Without options, you would have to buy and sell stocks at their current market price. So, options trading is generally safer than stock trading.
The best time to buy an option is when you think the price of the stock you’re interested in will change before its expiry date. If you expect the price to increase, you need a call option; if you expect it to drop, you want a pull option. If you need help deciding on when to buy stocks, we have compiled a list of excellent stock screeners that will help you make a profit.
Employee stock options are just options that are given to employees as compensation for their work. There are two types, ISOs and NSOs. ISOs are given out only to employees and provide a more favorable tax treatment. NSOs can be given to outsiders in addition to employees, and they come with a less favorable tax treatment.
The main benefit of stock options is the minimization of risk associated with stock trading. If you receive an option from your employer, they have given you a potential ownership stake in the company, which can lead to a dividend and a chance to advance up the corporate ladder. You can also purchase them through a broker or by yourself through direct access trading. Being able to answer “what are stock options and how to make the best use of them?” can allow you to reap substantial profits at low risk.