What Are Stock Options And How Do They Work?
Stock options are contracts that allow the holder the right to buy or sell shares at a fixed price at or before a fixed period of time (called the expiration date). First introduced in the 1970’s, stock options have become a creative and highly flexible financial derivative instrument that allows traders to profit with low risk.
Options contracts come in two flavors; call options and put options. Calls options provide the holder the right to buy the asset (stock) while put options give the holder the right to sell the asset.
How Stock Options Work
What makes stock options unique is that you’re not actually selling or buying any physical asset. You are entering into a contract that simply allows you the “option” to buy or sell an asset at some point in time. This is where they offer their flexibility. The contract states a price and a set period of time; within this period of time, you can buy or sell at the stated price. Although the market value may change, the price that you will buy or sell the asset for stays the same. This value is called the strike, or exercise, price.
When you exercise your option, you can buy (call) or sell (put). Or, you can do nothing at all. If an option turns out to be not such a great deal, you can let it expire without exercising it. For example, if the stock’s market value falls, you can just let the call option die, and all you’ve lost is the premium you paid for it.
Employee Stock Options
Stock options are exchanged through the stock market. They’re also offered to employees of certain companies. Companies offer options to make working for them more attractive and to keep employees. The way most plans work, the option is given to employees during the duration of their employment. They can exercise them at any time. This way, employees benefit when the company grows. They get to have part ownership in the company where they’re employed.
Different Styles Of Stock Options
There are two main styles of options that determine when you can “exercise” the option; options are either American or European styled options. The main difference is that European options can’t be exercised until the expiration date. American options can be exercised at any time. This makes a huge difference in determining the value of these options. Most stock options today are American options. There are also Asian options, exotic options, and other types that are not traded as often.
Stock Options Vs. Futures
Stock options are often mistaken for futures, but these two derivative instruments are extremely different. At the outset, they have many similarities. Both are contracts for a future transaction. The major difference between the two is that with futures, you’re obligated to transact the underlying asset at the price traded, whereas options you can choose not to exercise the transaction if the price of the underlying asset has proven unfavorable to you.
This has major ramifications on you as an investor. When you buy futures, you’re much more at the mercy of the market. If the underlying asset’s value drops, you’re still obligated to buy, which means that you lost money on the deal. Stock options are much more advantageous because you aren’t obligated to buy. There is much less risk in stock options than in futures.
Stock options offer a flexible and low-risk way to trade stocks. You’re simply purchasing the right to buy or sell, but it’s not set in stone. There are lots of ways to trade stock options on the market and make a great profit.