Stock Options Explained: What They Are and How They Work

Stock options can refer to two related yet different things. The first, known as an exchange-traded option, is an agreement that can give you the option to buy or sell stock at a specific price by a specific date. It's an investment, albeit one that typically carries more risk than traditional stock investing.

The second, known as employee stock options, is a form of equity compensation that an employer may offer employees, early investors, advisors, etc. This type of stock option isn't a tradeable asset the way exchange-traded stock options are, but it still involves an agreement to buy stock at a certain price by a certain date.

Because stock options can expire worthless, investing in them or accepting them as compensation should be cautiously approached. But experienced traders can use options in various ways, including limiting potential losses.

All kinds of investors can access stock options with some of the best online brokerages and investment platforms.

Here are the basics of trading stock options, hedging strategies, and the risks involved with options contracts.

What are stock options?

The first key to understanding stock options is to first make sure you're referring to the right type. As mentioned, there's more than one definition, but here we'll focus on exchange-traded stock options. Technically, there are also off-exchange options, known as over-the-counter (OTC) options, but those generally aren't available to retail investors.

Either way, these are investable options based on an agreement between two parties, and exchange-traded options can be bought and sold through a brokerage, much like publicly traded stocks.

When you purchase a stock option, you have the right — but not an obligation — to buy or sell a stock at a specific price within a certain period. If you're the option seller, you must fulfill the agreement based on the buyer's decision. Typically, one stock option contract represents 100 shares of the underlying stock, meaning that a $1 move in the stock price can mean roughly a $100 move in the option price — although several other factors such as time-to-expiration and expected volatility affect option prices.

"Stock options allow you to benefit from a change in a company's stock in a heightened or leveraged manner," explains Yves-Marc Courtines, CFP and principal of Boundless Advice LLC. "The gain may be from an increase or decrease in the stock's price."

Terminology in stock options trading

Several key terms are important to discussing and understanding how options work:

• Holders and writers: The option holder purchases the option, and the option writer sells the option.
• Exercising an option: The holder exercises an option when they act on the contractual right of the option to buy or sell the underlying stock at the agreed-upon price.
• Expiration date: The end of the contract, after which the right to purchase or sell the underlying asset can no longer be exercised.
• Premiums: The holder pays the writer a nonrefundable fee, known as the premium, for the option. However, the holder can potentially recoup some, all, or more than the premium based on selling the contract prior to expiration to another buyer; its value can depend on factors such as the expiration date and the underlying stock's price and expected volatility.
• Strike price (exercise price): The price at which the holder can buy or sell the stock up until a preset date.
• Intrinsic value: The value of a stock option if exercised immediately, based on the difference between the current underlying asset price and strike price. For example, a call option with a strike price of $101 and an underlying stock price of $104 has an intrinsic value of $300 based on exercising at $101 and then selling 100 shares at $104. In reality, though, that wouldn't be the actual profit due to factors such as premiums and trading fees. If the option is not in the money (meaning the strike price is above the stock price for call options, and vice versa for puts), then the intrinsic value is zero, because there's no profitability in exercising.
• Time value: This refers to the value of a stock option beyond its intrinsic value. It is also called extrinsic value and is based on the market's view of the probability of favorable movement in the underlying stock price before the expiration date. Generally, the further away the expiration date, the higher the time value, as there's more time for pricing to move in favor of the option holder.

Types of stock options: call and put options explained

Different types of options contracts are traded and categorized in varying ways. The two main types of options are:

• Call options: The holder can buy the underlying stock or other asset at the strike price before the expiration. Call options generally increase in value as the underlying asset's price rises. Long calls have unlimited upside potential to buyers, so investors use them to speculate on the underlying asset's price. The maximum loss potential is the initial premium.
• Put option: The holder can sell the stock at the strike price by the expiration date. Put options increase in value as the price of the underlying asset falls. A long put is a short position on the underlying assets, which investors use to bet on a stock losing value or for purposes like hedging against current holdings in their portfolios. The latter risk management strategy is referred to as protective puts.

You can buy or sell either type of option. If selling calls or puts, the risk is the opposite. You get the premium up front and can keep it no matter what (though you have to pay to close out the position early). It's up to the buyer whether or not to exercise though; you're obligated as seller to act if they exercise.

But if you sell a call option and the stock price rises above the strike price, your potential losses are unlimited, as you could have to buy 100 shares at whatever the stock price at that time is and then sell them at the agreed-upon strike price for less. However, many investors use covered calls, meaning you own at least 100 shares of the underlying asset (as opposed to naked calls, where you don't own enough underlying shares and the potential losses are truly unlimited).

With covered calls, your losses are typically only opportunity costs, as any losses on the call itself are offset by gains in your underlying stock holding. That said, covered calls can somewhat lock you into a position, as you can't sell those corresponding shares while owning the option. Thus, if you want to exit early, you have to buy back the option before selling your underlying shares, which could mean paying more for the option than you sold it for.

Similarly, when selling puts, brokers often require you to have enough cash on hand to buy 100 shares at the strike price. These are called cash-secured puts as opposed to naked puts (when you don't have the cash on hand). If the asset price does fall below the strike price, you have to purchase the underlying shares for the agreed-upon price. For example, if you sell a put at $100 and the stock price falls to $95, you'd spend $10,000 to buy 100 shares at $100 per share, but the value of these holdings would only be worth $950 based on the current $95 stock prices. Granted, these are paper losses until you sell the underlying asset, and it's possible that the underlying stock will regain value. Still, your potential losses are as much as the value of exercising the stock option, such as if you buy in at $100 per share for $10,000, but the stock goes to $0, meaning you could technically lose all $10,000.

All that's to say, both buying and selling calls or puts can have significant risks. You might lose the premium if buying them or face steep losses when selling them if the underlying stock price moves against your position.

There are also differences between American-style and European-style options. With American-style options, the holder (aka the buyer) can exercise the option at any time before the expiration date, while European-style options can only be exercised on the expiration date.

Pros and cons of stock options

Stock option pros

• Leverage over a larger position in an asset at a cheaper price than directly buying
• Can reduce potential losses by using options as a hedge
• Potential to generate income
• Less risky than shorting stock by limiting losses
• Versatile

Stock option cons

• Risk of significant loss for both buyers and sellers
• Options lose value over time and can expire worthless, unlike owning assets directly
• Can be more volatile than underlying stocks
• Requires thorough market knowledge and understanding of complex trading concepts
• Can have high commission and fee costs

How stock options work

Stock options allow holders to buy or sell a specific number of shares of an underlying asset at the strike price on or before the expiration date. You're not obligated to trade the underlying asset, such as if the stock price doesn't move in your favor and you don't want to take possession of the stock.

Stock options provide investors with significant leverage. One option contract typically provides the right to buy or sell 100 shares of the underlying stock, and the premium is a fraction of the price of those 100 shares. If used effectively, selling options is an effective way of generating income from fluctuating stock prices.

"If you want to dip your toe in, you could write a covered call," says Morrison. "It means you own the stock, and you write a call, meaning you sell a call."

For example, you own 500 shares of company XYZ, which trades at $80 a share, and you sell five call option contracts — each contract is for 100 shares. You collect $1.20 in premiums per share and receive $600.

The holder has the right to purchase the 500 shares from you for $85 a share (the strike price) during the next six weeks. They may let the option expire if the stock's price never exceeds $85. But, if it does, the holder can exercise the option, and you'll lose out on potential gains. In either case, you get to keep the $600.

The role of options exchanges

Options exchanges are a crucial element of options trading. They are specialized marketplaces facilitating option trading and ensuring fair and regulated trading among buyers and sellers. Option exchanges assist in market liquidity and efficiency and help investors make more informed trades through the transparency of the exchange's publicly displayed order book via the Options Price Reporting Authority (OPRA).

While the trades take place through these options exchanges, retail investors can access options via their brokerage accounts, who then route orders accordingly; some advanced traders choose brokers that allow them to select where their trades take place, however.

Some of the major options exchanges in the U.S. include:

• Chicago Board Options Exchange (CBOE)
• Boston Options Exchange (BOA)
• Miami International Securities Exchange (MIAX)
• NASDAQ PHLX (previously the Philadelphia Stock Exchange)
• NYSE American Options
• NYSE Arca
• International Securities Exchange (ISE)

Pricing of stock options

Stock option pricing is determined using the option's intrinsic and time value.

The intrinsic value is the difference between the stock price and the predetermined strike price to reflect the option's overall profitability. Time value represents the possibility that the stock price moves in your favor before its expiration date. Over time, the time value decays, and the option loses value for holders as it expires. However, time value is not strictly about time but also factors like interest rates and expected volatility that affect the value of holding an option.

Options pricing typically involves complex mathematical pricing models that account for these types of factors. One of the best-known pricing models is the Black-Scholes model. However, some advanced investors might weigh factors differently and use their own models.

Uses of stock options in investing

Stock options are often utilized as a hedging strategy to reduce risk and potential loss in your investment portfolio. Some hedging strategies using stock options include:

• Protective puts: A common risk-management strategy for investors buying put options to limit risk on an already owned asset. Similar to an insurance strategy, protective puts limit losses if the price of the underlying stock drastically falls. That way, your potential gains from the put offset some losses in the underlying asset. It's best when used in volatile markets or as a hedge against short-term declines.
• Covered calls: Provides a short-term hedge against minor price shifts (up or down) while holding a long position in an underlying asset already bought by the investors. This strategy is best used by investors who predict that the underlying stock will remain nearly the same. However, you'll have to forfeit your stock gain if the asset's price exceeds the option's strike price.

Risks of trading stock options

Investing always involves risk, and the risk associated with stock options can be much higher than that of buying and holding a company's stock.

"You can lose all the money you put in when you buy a stock," says Theresa Morrison, COO at BlockSpaces. "If you buy or sell an option and you don't know what you're doing, you could lose the money, your car, and your house."

That's especially true if you're selling naked calls that have unlimited loss potential. Even with other options, if you make enough ill-advised trades, you can quickly lose a lot of money.

For buyers, there's a chance that the value of the underlying stock moves in the wrong direction, and they'll have to let the contract expire worthless. A similar risk of investing in stock options can occur with wrong timing, as there is a chance that the underlying stock does move in the right direction, but not enough before the contract expires.

Even though investors can also use options to limit their potential losses, these are very complex instruments that beginners often lose their shirts on. Don't buy or sell options until you understand what you're getting into.

What are employee stock options?

Employee stock options are a type of employee equity compensation. Companies may offer options as part of a sign-on bonus or retention program.

To draw a comparison, Morrison says, "An employee stock option is always a call option because you have the right, but not the obligation, to buy the company's shares at a fixed price during a certain period of time."

Courtines points out that, unlike traded stock options, equity offers are granted rather than purchased. Still, there's some risk involved. "What you're giving up is a paycheck," says Courtines. "Instead, you're getting an option that could be worth more but that could also expire worthless."

You may also have to wait until an option vests before exercising it. For example, a portion of your option may vest each year during the first five years in a new job.

Common types of employee equity compensation

Companies can offer two types of stock options — incentive or non-qualified.

• Incentive stock options (ISOs): An ISO can offer tax advantages because your profits could be subject to the capital gains tax rate if you exercise after meeting certain holding requirements. You can also potentially defer taxes after exercising, although some exercises trigger the alternative minimum tax (AMT).
• Non-qualified stock options (NSOs): Don't receive a special tax treatment. You'll generally pay ordinary income taxes on the difference between the current fair market value and your exercise price.

Other common types of equity compensation also exist, but these aren't technically options.

• Restricted stock units (RSUs): Companies may offer RSUs that you'll receive based on a vesting schedule or for meeting certain goals. "RSUs look more like a cash bonus," says Courtines, "and they've become the dominant form of incentive compensation."
• Employee stock purchase plans (ESPPs): The company lets you buy its shares at a discount — often 5% to 15%.

What to ask if you're offered or have equity compensation

Equity compensation programs are a popular way for companies to attract and retain employees. Here are a few suggestions and points to consider if you're offered or receive equity compensation:

• If you receive ISOs, Morrison suggests working with a professional to create an exercise strategy and five-year plan to account for the potential tax implications.
• When working at a private company, you may want to hire a financial advisor to help determine the value of your options or equity.
• If you receive RSUs in a private company, ask if a liquidation event, such as an IPO or merger, restricts them.
• If offered the options or equity grant when taking a job, be sure to actually accept them — it isn't always automatic.
• You may need to exercise your options actively, or they might expire.

Also, consider how the equity impacts your entire financial position. For example, you may want to immediately sell shares from RSUs and ESPPs and use the proceeds to diversify your portfolio. Otherwise, your income and a large portion of your portfolio may depend on a single company's success.

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