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Stock options are an additional way to invest and make money in stocks, but how do they work? In simple terms, a stock option lets you buy or sell a stock at a specific price on or before an expiration date. If the stock's price goes higher than your purchase price—or lower than your sale price—before the stock option expires, you may turn a profit.
Investing in stock options is more complicated—and potentially riskier—than investing directly in stocks, mutual funds or exchange-traded funds (ETFs). If you're interested in trying stock option investing, it's critical to study up on the mechanics and strategy behind it. For a quick summary of what stock options are, how they work and how to calculate their value, read on.
What Is a Stock Option?
A stock option is a contract that gives the owner the right to buy or sell a stock at a specified price and time. The owner has the right, but not the obligation, to buy or sell before the option expires.
There are two main types of stock options: calls and puts.
- Call options give you the right to buy shares of a stock at a specified price on or before expiration.
- Put options give you the right to sell shares of a stock at a specified price on or before expiration.
Purchasing an options contract costs money. The cost per share for purchasing an option is called the premium. Whether or not you decide to exercise your options and buy or sell shares of the underlying stock, you always pay the premium. Think of it as the price of your contract.
Employee Stock Options
Some companies offer their key employees stock options as a benefit. Typically, these options have a vesting schedule that grants options over a period of time and an exercise window that dictates when you can exercise your options. Employee stock options can be lucrative if the company's stock value rises during the course of your employment. Many employers also see options as an incentive to work hard to help the company succeed.
Stocks vs. Stock Options
Stocks and stock options are related but different. When you buy stock, you're buying an ownership stake in a company. When you purchase a stock option, you're buying the right to buy or sell a company's stock—without buying or selling the stock itself (unless you exercise your options).
Investing in stocks generally means investing in a company's future health and growth. You believe the company's value will trend upward over time and perhaps pay dividends along the way.
Stock options add a time element to your calculations. You're betting that a company's stock price will either rise or fall by a given margin over a specific period of time. If your calculations are off, you can lose your premium and walk away with nothing.
Because of this potential to lose money—and the added complexity of trying to predict stock price movements over a short window of time—stock options are considered riskier than stocks. Though options provide an additional way to make money on stocks, trading stock options also requires additional levels of skill.
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How Do Options Work?
Here's a quick example of how a stock option works. Say you purchase a call order for 100 shares of XYZ stock with a strike price of $10 and an expiration date of January 18, 2025. The premium is $1 per share or $100 for your contract of 100 shares.
Terms to Know
As a reference, here are a few key terms to remember.
- A call order gives you the right to buy.
- A put order gives you the right to sell.
- The strike price is the price at which the contract may be exercised.
- The expiration is the date after which the option can't be exercised; it has no value and no longer exists when it expires.
- The premium is what you pay to purchase an option.
Between the date of purchase and the expiration date, there are two possible outcomes for our sample contract.
- The price of the stock rises. Suppose that by January 18, 2025, shares of XYZ are selling for $25. You can close your position by selling your option for the difference between the market price and your strike price—in this case, $1,500 ($15 per share x 100 shares), minus your $100 premium. Or you can exercise your options and buy 100 shares of XYZ for $1,000, less than half its current value.
- The stock price stays below your strike price. You don't want to buy XYZ stock at your $10 strike price when it's trading on the open market for less, so your contract expires worthless. You are out $100.
Put options are a hedge when the stock price goes down. If you bought a put instead of a call, you could close your position by selling your contract for the difference between the market price and your strike price, minus the premium. If the price dropped to $6 a share, that translates to ($10 - $6) x 100, or $400, minus the $100 premium. Or you could buy 100 shares for $600 and sell them for $1,000. Either way, your profit is roughly $300.
Every option has a buyer and a seller. You can sell calls or puts instead of buying them, though the rules for sellers are slightly different. As a seller, you collect the premium, which guarantees you make some money on the transaction. However, unlike buyers, sellers are obligated to sell or buy shares as promised if the buyer asks: The "option" is in the hands of the buyer.
Where to Trade Stock Options
Many brokerage firms offer stock options trading; some platforms are specialized for trading options. Check with your brokerage for details or shop around for a firm (or app) that best meets your needs.
How to Calculate the Value of Options
Estimating the value of your stock options is simple when the underlying stock is publicly traded. Find the current price of your stock and plug it into this formula:
(Current Share Price — Strike Price) x Number of Shares = Option Value
If your stock is trading at $150 and your strike price is $120, each 100-share contract is worth $3,000: ($150 - $120) x 100. For a put, convert a negative value to a positive and a positive value to a negative. In this example, the $30 difference between the current price and the strike price converts to -$30 and a $3,000 loss—a good reason to let the contract expire.
To estimate your net profit, make sure to account for the amount you paid in premiums and any transaction fees or commissions that apply.
Employee Stock Options
To calculate the value of employee stock options in a non-publicly traded company, start by determining the stock's current value. Your company's human resources or finance department may be able to help.
The underlying formula for estimating your stock options' value is the same as for a regular call option: If you have an option to buy 10,000 shares of company stock for $10 a share, and the current share value is $18, your profit is roughly $8 per share. Multiplied by 10,000 shares, that's $80,000.
If you don't have the cash to buy your stock, you may be able to "exercise and sell," or buy and sell your shares in a single transaction. Alternatively, you may be able to "exercise and sell to cover," in which you only sell enough stock to cover the cost of buying shares at the strike price. This allows you to use your profits to buy (and hold) company stock.
The Stock Advice
Stock options can provide additional opportunities to make money on stocks—beyond buying and selling stocks themselves. Though stock options offer the potential to make money quickly, they also require insight (to know whether a stock price is headed up or down) and attention (to monitor pricing and decide whether it's time to close your position or exercise).
If you're interested in options, the stock advice is to learn as much as possible about the strategy behind options trading, and to start small. Investing a small portion of your portfolio in options can help minimize risk as you're mastering your skills.