If you are looking for an easy way to create profit, stock options might be the right financial product for you. Companies often grant their employees with stock options. Not only is it a smooth and cheap way for employees to start their investing practice, but it is also an excellent system for employers to attract new employees or contractors. This article explains how stock options work, why they can benefit you, and the risks involved.

What Is a Stock Option?

  • A stock option is a contract that allows you to buy or sell shares of stock for a pre-agreed period and price. A stock is a portion of ownership in a company.
  • One stock option is equivalent to 100 shares of stock, and offers the advantage of leverage. It means you can control more stock by purchasing a stock option than if you just bought the underlying stock, while generally paying less.
  • Stock options are an incentive that companies can offer to their employees, consultants, and contractors.
  • There are two types of stock options: The incentive and the non-statutory stock options.

What Are Options in Stock Trading?

An option is a derivative financial instrument giving the buyer a right to buy or sell an underlying stock at a pre-determined price and date. It is not an obligation. There are two types of options: calls and puts. The ‘call’ allows the investor the right to buy stocks at an agreed-upon price within a pre-determined period. Owning a call is like being long a stock or bullish. On the other hand, a ‘put’ gives the investor the right to sell an asset at a specific price within a pre-determined period. Holding a put is similar to being short a stock or bearish.

Basics of Stock Option Trading

  • Stock options trading implies the use of calls, puts, or a combination of both. All of this happening before the expiration date.
  • The price at which you can buy or sell an underlying stock is called the strike price or exercise price. It doesn’t change, no matter how well or poorly the company performs.
  • A call option is ‘in-the-money’ when the share price is above the strike price. The difference between the share price and the strike price is called the intrinsic value.
  • Once you bought shares, you’re free to sell them immediately to make a profit. You can also hold them and bet that the stock price will increase more later. The price paid for an option is the premium.

Why Does a Company Offer Stock Options?

A company stock option is an opportunity to own shares in that organization. Startup companies often issue stock options to reward early employees when and if the company goes public. Fast-growing companies also reward employees with Employee Stock Options as an incentive to work towards growing the value of the company’s shares. Stock options can also retain employees within the company, thanks to the vesting process.  Should employees leave the company before they vest, they would lose their right to exercise them.

What Are Employee Stock Options?

Employee stock options are also referred to as ESOs. They are a benefit offered by companies to their employees and executives. ESOs are derivative options on the company stock and come in the form of call options; they give the employee the right to buy the company’s shares at a pre-determined price for a specific period. The terms of employee stock options are detailed in an employee stock options agreement. ESOs can have vesting schedules limiting the ability to exercise. Employees pay a tax when exercising their options and when selling their shares in the market.

How Do Stock Options Work?

The contract you sign with your employer specifies the grant date: the day your options begin to vest. You must wait for the vesting period to be over to exercise, in other words, to buy. In some cases, the options vest gradually, and you can exercise little by little.

What Is Stock Vesting?

Stock vesting is the period that employees must wait to be able to exercise their employee stock options. You can consider it as the process of earning an asset over time. So, unless your company allows early exercising, you are only allowed to exercise your right to buy on vested stock options.

If employees terminate their employment contract before the end of the vesting period, the company can re-purchase the shares at the original price. Companies often use vesting to retain current employees, encourage them to stay longer at the company, and as a performance motivation.

What Types of Employee Stock Options Exist?

Two types of employee stock options are available: the statutory, also called incentive stock options (ISOs) or qualified stock options (QSOs), and the non-statutory, also known as non-qualified stock options (NSOs).

Statutory stock options meet the requirements for preferential tax treatment for employees. The Internal Revenue Code and the IRS Publication 525 details what constitutes a statutory stock option. Any stock options that do not fall under that IRS definition is non-statutory.

The company specifies if it grants an ESO as a non-qualified stock option. An ESO can also become non-qualified if the underlying stock is disposed of through a disqualifying disposition.

How to Exercise Stock Options?

Exercising your options means you can buy shares of company stock. There are ways to exercise without putting up the cash to buy your options.  The Exercise-and-sell transaction implies you purchase your options and immediately sell them, having the brokerage handling the sale front you the money. They will then use the profit from the sale to cover your costs you to buy the shares, rather than having to use your own money to exercise.

Another way to exercise is the exercise-and-sell-to-cover transaction. With this tactic, you sell just enough shares to cover your purchase and keep the rest.

When Should You Exercise Stock Options?

You may already know you must act before the expiration date, but here is how to understand when the stock option chart shows you a green light.

When the stock price goes above the strike price, you will exercise a call. You can sell the shares immediately after you exercise and pocket the profit. If you expect a rise in your company’s shares price in the future, then you may want to hold your options and resell them later. If you exercise your options when the stock price goes below the strike price, you should wait for the price to rise not to lose money.

What Should You Do When You Leave the Company?

If your stock options are vested, they are yours. When you leave your employer, it is time to decide if you leave the money you invested in this employer’s retirement account untouched or if you transfer it over into another brokerage account to continue your investment process. You can learn how to trade your options and continue to maximize your investment.

What Are the Benefits of Stock Options?

Stock options give leverage because they offer the same price variations as a 100 share position in the underlying stock, while cheaper.

They are also a cheap and easy way to attract prospective employees and retain current employees. It makes the personnel feel like partners in the business. The motivation a prospective employee can find in owning stock options is the possibility of buying stock shares of the company at a discounted rate compared to the open market rate, then sell it and gain a profit. The retention of current employees who receive stock options thanks to stock option vesting.

What Are the Downsides of Stock Options?

The main downside of stock options is dilution. By offering shares to employees at a preferential price, employers dilute the profit per share of existing shares and the ownership of external shareholders. It drives down the price of individual stocks and frustrates existing shareholders. Another disadvantage is the risk that the company stocks don’t perform well or become worthless, leaving their holder empty-handed.

Stock options are an excellent instrument to create profit while maintaining leverage. To succeed in your trading adventure, you need to understand the market. That way, you can easily monitor the stock prices to decide when to buy or sell and make a profit. Learn more with the free option profit generator handbook. Whether you are a beginner trader or already comfortable, you can improve your game with these useful trading secrets.

Author: Jeff Bishop

One of the best traders anywhere, over the past 20 years Jeff’s made multi-millions trading stocks, ETFs, and options. He is renowned as an incredible trader with a deep insight and a sensitive pulse on the markets and the economy. Jeff Bishop is CEO and Co-Founder of RagingBull.com.

Even greater than his prowess as a trader is his skill and passion in teaching others how to trade and rake in profits while managing risk.

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