Stock‌ ‌Options: What They Are and How They Work

Have you been thinking about investing your money in stocks, but the market’s volatility has you second-guessing? Stock options are a great alternative to regular stocks and a profitable choice if you play your cards right. But what are stock options? How do they work? What types of options exist, and how can they be taxed?

What Are Stock Options?

If you know how stocks work, then perhaps you’ve heard of stock options. Stock options include the right (but not obligation) of an investor to choose to buy or sell a stock at a specific price and date. There are two main types of options: puts and calls.

In addition, there are a few other terms that an investor should be aware of, such as expiration date, strike price, employee stock option, premium, vesting date, and bid price. Note the explanations of these terms (and others) below.

• Stock put option

A stock put option is a type of stock option that gives the owner the right (but not obligation) to sell a previously specified amount at a predetermined price during a once-established time frame. These types of options are available on stocks, commodities, indexes, and currencies.

• Stock call option

A stock call option gives the owner the right (but not obligation) to buy a previously specified amount at a predetermined price during a once-established time frame. The price is also known as a strike price, while the time frame is the expiration date or time to maturity.

• Expiration date

An expiration date is the time frame during which a trader can bet on a stock that’s rising or falling and allow the trader to choose a date when the stock might rise or fall. This is an essential aspect of understanding stock options and stock trading, as it gives traders a chance to price the value of the put and the call correctly.

• Strike price (grant price, exercise price)

A strike price (grant price or exercise price) is the price of a derivative contract that can be bought or sold. For example, when a call option is in question, the strike price is the price at which a security can be purchased, while for put options, the strike price is the security’s selling price.

• Employee stock options

What are employee stock options? An employee stock option is a type of compensation given to employees by their companies by directly giving derivative options on the stock. These stocks are call options, which means that employees have the right to buy a company’s stock by the rules for a regular stock call option.

• Premium

A premium is a total amount investors pay up-front for stock options. Premiums consist of two components: intrinsic value and time value.

• The intrinsic value is how much money potential investors gain if they exercise the option at once. The inherent value equals the positive difference between the strike (or exercise) price and the asset’s current market value.
• The time value of a stock option entails the price an investor is willing to pay that stands above the intrinsic value, which signifies that the investment will eventually pay off.

• Vesting date

An employee stock option can’t typically be used immediately. Instead, a time frame exists where employees must stay with the company to be able to purchase the company’s stock. When the time frame is over, you can exercise your options. The date when this occurs is known as a stock option vesting date.

• Bid and ask price

The bid price is the highest price at which a potential buyer would buy a particular option, while the asking price is the offered price at which stock options will be sold.

How Do Stock Options Work?

Although anyone can use stock options, they are mainly used to boost employee morale. By offering stock options to prospective employees (and current ones), employers allow them to own stock of the company at a lower rate rather than cashing out through regular stocks.

So how do stock options work? The way employers retain an employee stock option is through vesting. All employees who own stock options are given a specific vesting date when they can exercise their options. Through vesting, employees are encouraged to stick around and follow all requirements to acquire their company shares.

A stock options example can be seen with your employer granting you 8,000 shares with a two-year vesting period, providing 4,000 shares at the end of each year. In this instance, for you to gain 4,000 shares, you’d need to stay in the company until the end of the first full year. To exercise all 8,000 shares, you’d be obligated to stay for the whole two-year vesting period. In the end, you would have the right to the company’s 8,000 shares out of your stock options.

Key Takeaways

European- And American-Style Options

Other types of stock options include European- and American-style options, which do not refer to a geographical difference, but option exercising.

• European-style stock options

European stock options can be exercised only at expiration, which means that if the stock price has moved, the investor would not be able to exercise the option at an earlier date and possibly sell the shares.

Ultimately, the call or put action will be exercised only on the date of option maturity. European options stop trading one day earlier than the American type of stock option—at the close of business on Thursday preceding the third Friday of the expiration month.

• American-style stock options

American stock options can be exercised at any time before expiration. They allow investors to profit according to stock price movements and catch the most favorable profit. Optionable stocks and exchange-traded funds have this style of options, while most broad-based indices have European-style stock options. The last moment of trading with an American index option is each third Friday of the expiration month (with few exceptions).

How to Exercise Stock Options

There are several ways you can exercise your stock options.

• Cashless hold

A cashless hold transaction can involve a broker who will facilitate the sale of stock options—a way to exercise stock options if you don’t have enough resources to buy the shares.

• Cash Payments 

Company stock options can also be exercised in cash. With some companies, the employers allow their employees to exercise their options when the employers sell some stock to cover the cost you sustained to acquire the stock.

• Selling all shares 

If you decide to sell all shares, you will not need to give up-front cash for transaction costs, and you’re not exposed to stock price volatility. But this type of exercise may have below-beneficial tax implications.

Stock Options and Taxes

Regarding taxation, stock options are categorized into two following plans: Incentive stock options (ISOs), which are statutory and plans granted under purchase, and nonstatutory stock options (NSOs), which come with no plans.

• ISOs (Incentive Stock Options)

ISOs (Incentive Stock Options) are a type of employee stock option characterized by the right to buy company stock shares at a discounted rate, together with possible tax breaks on the profit.

The key to understanding stock options and taxation of this kind is that the ISO’s profit is generally taxed at the capital gains rate and not the higher rate for ordinary income. Typically, ISO stock is awarded only to top management and highly-valued employees. (ISOs are also called statutory or qualified stock options.)

• NSOs (non-qualifies or nonstatutory stock options)

NSOs (non-qualifies or nonstatutory stock options) is a type of employee stock option that requires you to pay ordinary income tax on the difference between the strike (grant or exercise) price and the price at which you exercise the option when conducting stock options trading. Prices of this type of employee stock option can often be similar to the market value of the shares.

Conclusion

Whether you’re an employer or an employee, stock options can be of great benefit. A stock option is the right of an investor to choose if they wish to buy or sell a stock at a specific price and date—which can be lower than what the market asks for regular stock. Although it might be risky, stock options can prove to be quite profitable in the future if you’re smart with your investments.