You have most likely heard of stock options as part of an employee compensation package. Tech companies and startups are famous for attracting talent with stock options.
In this context, “stock option” refers to employees being granted a number of shares that they can purchase at a market price as part of their overall compensation. The benefit is if the market price goes up, they can exercise their options and enjoy a gain, whereas if it falls, they’re out nothing (they simply forego exercising their options).
Stock options aren’t limited to employee compensation, however. There are stock options that can be publicly traded.
What Are Stock Options?
A stock option gives an investor the right to buy or sell a stock at an agreed-upon price and expiration date. As such, it is one step removed from the underlying stock itself and among the many “derivatives” that can be traded and used for hedging, leverage, and other financial investing purposes.There are two forms of stock options that trade on the stock exchange: a call and a put.
A call option is the right to buy a stock at a stated price within a specific time frame.
A put option is the right to sell the stock at a stated price within a specific time frame.
Investing in options is an area of finance that can be difficult to understand, while also presenting higher risk than most people would want to take on if they truly comprehended it.
Key Parts of Options to Understand
- Strike price: the trigger or level that tells you whether you’re above or below the market price and thus whether exercising the option before the expiration date should happen.
- Contract size: the number of underlying shares that you are considering buying. One contract is equivalent to 100 shares of the underlying stock.
- Premium: the price paid for an option, calculated by taking the price of the option and multiplying it by the number of contracts bought x 100.
- Expiration date: refers to the time before your option is no longer in force. Dates out further are more expensive than short-term dates as they give you what is called more time value. These dates are fixed and on a schedule.
Behavioral Aspects of Options
- Volatility is the nature of stock options, and when the market is volatile, options are even more volatile. This means you could lose sleep watching your option surging high one day, only to fall precipitously the next.
- The price premium you pay has a two-fold purpose: the intrinsic value and the time value. The time value part will decay with the passage of time. Thus, near-expiration-dated options will be priced less than those that have expiration dates farther down the line.
- Different option strategies are employed with different purposes and objectives, each with its own risk/reward profile. If you expect market volatility, you may buy a straddle or a strangle. Likewise, if you expect a market that will be range-bound, you may sell that straddle or strangle. There are butterflies and covered calls if the market expectation is slightly bullish or bearish.
- Some investors will choose to buy cheap options, hoping the stock will rise and earn them a good return. They buy out-of-the-money strike-priced options (where the underlying stock price is significantly different than the option strike price) because these are available at a low premium. But the probability of the stock getting near the strike price is then also low. Better to invest in at-the-money or slightly out-of-the-money strike prices because there is a greater chance of the option being exercised.
A Stock Example: Tesla
Let’s take Tesla as an example. If you’re a Tesla investor, for the past year, you’ve watched the stock trade in a range from $138.80 to $488.54. You’ve seen put options, that is, the right to sell Tesla shares, trade with volatility, subject to significant swings and downdrafts.Yet Tesla investors are bullish on the stock, and it has been roaring upward since President-elect Donald Trump won the November 2024 election and named Tesla CEO Elon Musk to head up a cost-cutting, proposed effort called the Department of Government Efficiency.
You’ve chosen the expiration date of Feb. 21 to give yourself time to see the market digest the financial results of Tesla’s fourth quarter of 2024, to be announced on Jan. 29.
You believe the enthusiasm was largely speculative—that the stock price got carried away on mostly strong momentum without being able to justify a high stock price that now reflects a stock price-to-earnings ratio of about 10 times historical stock averages.
You believe that following the earnings announcement, the stock price will fall hard, and as it does, your put option will likely increase proportionately. This isn’t entirely true, because other market factors come into play, such as the possibility that many other investors agree with you and have bid up the put option in reaction to the soaring stock price.
Summary
Options trading is not for most people. Derivatives—that is, financial vehicles once removed from underlying assets—are mostly the bailiwick of professional, seasoned, institutional traders. But allocating a small amount of your portfolio—maybe 5 to 15 percent—to speculations is considered reasonable by the standards of most financial advisors.So, if you want to learn, experiment, and practice, be aware that if the stock price doesn’t move the way you thought it would, you could find yourself at the expiration date of the option with zero value attached to your investment.
Assess your risk tolerance as options are risky. Understand your comfort level with losses that can be up to the entire option investment. Align your strategy with overall investment goals (hedging your existing positions, speculating on price movements, or simply trying to generate income).
Be aware of the tax consequences of options trading. Short- and long-term capital gains taxes can impact your net returns. Conduct research and analysis of the underlying asset and the current market conditions. Then, stay informed about news and events that could possibly impact the underlying asset’s price.
