Stock Option

A stock option is a contract that gives you the right to buy or sell an underlying stock at a predetermined price before or on a specified date. Call options are linked to an expectation of a price rise, while put options are linked to an expectation of a price fall.

• A call option gives you the right to buy the underlying asset.
• A put option gives you the right to sell the underlying asset.
• The strike price determines the price at which the underlying asset can be bought or sold.
• The premium is the price paid for an option.
• In the source example, 1 contract represents 100 underlying shares.
• Stock options can be used for hedging, speculation and income generation.

A stock option, also called an equity option, gives you the right, but not the obligation, to buy or sell a stock at an agreed-upon price within a specified period.

Since its underlying asset is a stock or stock index, a stock option is a form of equity derivative. The two basic types are call options and put options.

A call option gives you the right to buy the underlying asset. A put option gives you the right to sell the underlying asset.

A stock option is a contract between two parties. The buyer receives the right to buy or sell the underlying stock at a predetermined price, while the seller of the option is called the option writer.

The buyer pays a premium for this right. Whether the option is exercised depends on factors such as the stock price, strike price and expiry date.

Here are the key components:

Stock options come in two basic forms: call options and put options.

Neither type obligates the option holder to exercise the option. The holder has the right to exercise it under the terms of the contract.

Employee stock options, or ESOs, are a form of equity compensation offered by some companies to employees or executives. They effectively give employees an opportunity to buy company shares under specified terms.

These differ from listed equity options traded in the market. Employee stock options are restricted to the corporation issuing them to its own employees.

Some companies, particularly startups, may include stock options in an employee compensation package. Employees should understand the terms of their options before exercising or selling them.

Employee stock options generally involve a grant, a vesting period, an exercise price and an expiration date.

Here is how they typically work:

1. Receive the options: The company grants you stock options that give you the opportunity to buy company shares at a specified price.
2. Complete the vesting period: You may need to remain with the company for a specified duration before becoming eligible to exercise the options.
3. Check the exercise price: This is the predetermined price at which you can buy the company's shares.
4. Review the expiration date: You must exercise eligible options before their expiration date. Unexercised options may become worthless after this date.
5. Assess the stock price: The value of the options can increase if the company's stock price rises above the exercise price.

The source outlines several forms of stock-based compensation and option plans used for different employee and company requirements.

Incentive stock options

Incentive stock options, or ISOs, are primarily designed for employees. The source states that they can offer favourable tax treatment when specific holding periods and other eligibility requirements are met.

These plans can encourage employees to maintain a long-term association with the company.

Non-qualified stock options

Non-qualified stock options, or NSOs, can be offered to a broader group, including employees, executives and consultants. Employers may also have greater discretion in setting their terms and conditions.

The source states that income from NSOs is typically subject to ordinary income tax at the time of exercise.

Restricted stock units

Restricted stock units, or RSUs, give employees the right to receive company shares at a future date, subject to specified conditions.

Unlike traditional stock options, RSUs do not require an upfront purchase. They may vest over time or after specified performance goals are achieved.

Additional Read: Future and Options Trading

What are the key features of stock options?

Several terms determine how a stock option works. The key features include the expiry date, strike price, contract size and premium.

Expiry date

An option has a specified expiration date. This date is important because it determines the period during which the option remains exercisable under its terms.

The source also identifies the expiry date as a factor used when determining the time value of put and call options in option pricing models.

Strike price

The strike price is the predetermined price used to determine whether an option can be exercised.

For example, the source describes a trader buying a call option with a specific strike price if the trader expects the underlying stock price to rise.

Contract size

A contract represents a specified quantity of the underlying asset.

Source data point: 1 contract = 100 underlying shares.

Premium

The premium is the price paid for an option.

Source formula: Premium = call price × number of contracts × 100.

What should you consider before dealing with stock options?

Before exercising, buying or selling stock options, you should understand the terms and risks involved.

Tax implications

Tax treatment can differ based on the type of option and the period for which shares are held. The source recommends understanding the applicable tax consequences before exercising options or selling the underlying stock.

You may seek guidance from a qualified tax or financial professional to understand the tax treatment applicable to your situation.

Risk and reward

Stock options can offer financial gains if the underlying stock price moves in the expected direction. However, they also involve risk.

If the stock price does not move beyond the exercise price as required by the strategy, an option may not become profitable. You should assess the risk and potential outcome before taking a position.

Diversification

The source advises employees with stock options to consider the concentration of their investments. Holding too much of your financial exposure in one company's stock can increase concentration risk.

Diversification can help reduce dependence on a single investment.

How are stock options traded?

A stock option contract gives the buyer the right to buy or sell underlying stocks at a predetermined price within a specified period.

Here are the basic points:

• The seller of the option is called the option writer.
• The option writer receives the premium paid by the buyer.
• A call option gives the holder the right to buy the underlying asset.
• A put option gives the holder the right to sell the underlying asset.
• Option prices are determined by market forces of supply and demand.
• Stock options can be used for hedging, speculation and income generation.

How can a stock option strategy work? An example

The following example uses TechGen Innovations, a fictitious company created solely to explain how the strategies described in the source work.

The securities quoted are for example purposes only and not a recommendation.

Strategy 1: Writing put options

Mr. X believes that TechGen Innovations shares will remain above a specified level. He decides to write put options.

If the stock price remains above Rs. 1,500 at expiry, the options expire worthless according to the example, and Mr. X retains the premium.

If the stock price falls below Rs. 1,500, the put option holders can sell the shares to Mr. X at the strike price. This can result in a financial loss because he may be required to buy the shares at Rs. 1,500 each.

Strategy 2: Buying call options

Alternatively, Mr. X buys TechGen Innovations July call options.

If the stock price rises above Rs. 2,000 by the option's expiration date, the example states that Mr. X can exercise the option and buy the shares at the strike price.

If the stock price does not reach Rs. 2,000, he can allow the option to expire and loses the premium paid for the option.

These examples show how different option strategies can produce different outcomes based on the underlying stock price and the terms of the contract. You should understand the mechanics and risks before using any options strategy.

A stock option gives you the right, but not the obligation, to buy or sell an underlying stock at a predetermined price within a specified period. Call and put options are the two basic types.

Employee stock options are different from listed market-traded options and form part of compensation offered by some companies. Before exercising, buying or selling stock options, you should understand their terms, expiry dates, pricing and potential risks.