Stock options give the person who owns them the right to buy or sell a share at a certain price on a certain date. Usually, a stock option gives you control over 100 shares. There are two different how stock options work: call options and put options. We’ve summed up the most important points in this article.
What are stock options?
Stock options are a type of financial instrument called a “derivative.” The value of a stock option is based on or permanently derived from the value of the underlying share. Since options can also be traded on other securities, indices, currencies, or derivatives like futures, the underlying reference is often called the underlying asset or underlying. Stock options are backed by shares of a publicly traded company.
Stock options are basically a standard contract between two parties. The terms of the contract are standardized. Each stock option comes with
- A set deadline and term until that date,
- A fixed strike price (also called a base price or a strike),
- A fixed amount of the underlying asset (usually 100 shares for stock options) can be delivered at the strike price when the option is due.
So, a stock option is not a share in a company. Instead, it gives the owner the right to buy or sell a set number of shares at a set price when the time comes.
Note that the person who owns the share option also gets the right to vote. If the owner of the share option decides to use it when it comes due, the seller of the share option, who is called the “standstill holder,” has to do what was agreed upon. Because of this, stock options are conditional forward transactions.
How stock options work
Stock options are agreements between two parties: the holder of the option (the seller) and the holder (the buyer). At the start of a forward transaction, the standstill holder gets the share option in exchange for the so-called option premium from the holder. From now on, the holder of the standstill has to give the holder the agreed-upon service when it’s due if he wants to.
If the stock option is in the money, then it makes economic sense to exercise it. So, the person who has the right to the standstill wants the stock option to expire worthless so that he can get the whole option premium.
You can choose between put and call options when it comes to stock options or options in general. The put option is also called a “put” or “put,” and the call option is also called a “buy option” or “call.”
A call-share option gives the person who owns it the right to buy the underlying. If the call is used, the owner of the standstill must give the holder a predetermined number of pieces, in this case, 100 shares, at a predetermined price. As was already said, an exercise only makes financial sense if the share price is above the call holder’s “break-even point,” or earnings threshold. To figure out the break-even point, you add the paid option premium to the strike price of the call.
The owner of a put option has the right to sell the underlying asset.
If the put is exercised, the holder of the standstill must sell a specified number of pieces, in this case 100 shares, at a specified price.Only if the share price is above the so-called break-even point (earnings threshold) of the put holder does an exercise make economic sense. To find the break-even point, take the paid option premium and subtract it from the strike of the put.
When a person buys a stock option, they take what is called a “long position.” The person who holds the “standstill” must take a “short position” to match. So, stock options can be bought or sold at the beginning. Depending on this, the investor appears to be either the owner or the holder of a standstill.In the next section, the facts are shown again in a table.
|Call share option (purchase right)||Put stock option (right of sale)|
|The holder is granted the right
||The holder is granted the right
Styles and ways to work out
Stock options can be put into two different “styles” based on how they can be exercised. American options are stock options that can be used at any time during the term. If you can only do the exercise on the due date, you have a European option. In practice, American exercise types are used to exercise stock options.
Important: The exercise discusses when the underlying can be presented.The person who owns an option position also has the option to sell the stock directly on the market at any time during the term. So, the buying and selling of a stock option are not tied to how it can be used. In practice, even options with an American exercise type are rarely triggered temporarily because the remaining time value is lost. This value can only be realized if the option is sold on the market.
Exercise prices and examples
In technical terms, the strike price of an option on a stock is the price at which the underlying stock can be bought or sold when the option is exercised. The difference between the strike price and the current price of the underlying determines whether or not an equity option has real value. In the next part, we’ll look at two examples to show how this works.
Strike and call prices
Call stock options always have something called “intrinsic value” when the share price is above the strike price of the call. Let’s say that the strike price of the call is 100 USD and the price of the share is 120 USD. In this case, the call would be worth €20 on its own. If the person who owned the call decided to use it, he would be able to buy the share from the person who owned the standstill for USD 100. So, 100 shares of USD 100 each would be put into the custody account. So, the equivalent value is equal to 10,000 USD. Since the share is currently worth USD 120 on the market, the book profit would be USD 2,000 minus the option premium paid.
The holder could also decide not to exercise the option and just keep the profits. In this situation, the difference would be settled with cash.
Strike and put price
When the share price is less than the strike price of the put, the put option has an intrinsic value. Let’s say the strike price of the put is 90 USD, but the price of the share is only 80 USD. In this case, USD 10 is what the put is really worth. The settlement would follow the same plan as shown above. The holder has the right to sell the share to the standstill holder for USD 90, but he can only buy the share on the market for USD 80. The difference is the profit minus the amount paid for the option premium.
Difference between stock options and warrants on shares
Stock options and warrants are often used as synonyms for each other in specialized literature and by private investors. These are two different types of financial instruments that are similar only in how they are built. The way they work is very different. So, a difference needs to be made.
Options are a type of futures contract that is usually bought and sold on futures exchanges. Options are standardized in a number of ways, such as the size of the contract, how payment is made, and when delivery takes place. Since warrants are based on options in terms of how they are put together, they are also conditional futures. But most of the time, these deals are made directly with the bank that issued the bond. Also, warrants don’t have standard contract terms. Instead, the issuing bank decides on its own how the contract works.
Stock options: advantages
Stock options as a form of pay
Employees of publicly traded companies can use stock options as part of their compensation or bonus payments. Since these are called stock options, employees directly benefit when the price of the shares goes up. So, there is a reason to contribute to the company’s success in running its business.
Hedging business deals
You can also use stock options to hedge, which is called “hedging of a custody account.” For example, if an investor has a long position in a stock, he or she can buy a put to protect that position. Calls can be used to protect short positions in shares. For this, the investor has to pay the premium for the option. Since a stock option or an option contract refers to 100 shares, the hedge ratio should be taken into account when hedging the custody account.
Stock option trading
People often trade stock options for no other reason than to make money from rising or falling share prices. Because of the so-called leverage effect, trading in stock options is especially interesting for private investors. When you buy a stock option, you have to invest a lot less money than when you buy shares. Because of this, private investors can make higher percentage profits with less money. But the same is true for losses.
Different option strategies can be used to make regular cash flows in addition to trading on speculation. For instance, covered calls or cash-secured puts can increase the return on a stock account by a lot. Dividends and price gains are made up of dividends plus price gains. So, this is also possible with investments that last a long time.
Stock options: risks
In general, a risk is that the share price won’t go the way people think it will. Because of the leverage, the losses can be much bigger than they should be, depending on the options chosen. If a stock option was bought, the risk for the owner is that the option will expire without any value. In this case, the person who owns the option would lose as much money as the option premium cost. On the other hand, the risk is much higher when you first sell a stock option, which is called being a “standstill holder.”