Stock Options Explained: What They Are and How They Work

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What are stock options?
Types of stock options
How stock options work
Pros and cons
Uses of stock options
Risks
Employee stock options
Types of employee equity compensation
FAQs

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A stock option is a contract that gives you the right to buy or sell a stock at a certain price in the future.
Stock options can be used to hedge against potential losses in your portfolio.
Employee stock options are a popular way for startups and public companies to attract and retain employees.

Stock options refer to two very different things. The first is an agreement that can give you the option to buy or sell stock. The second is a form of equity compensation that an employer may offer prospective and current employees.

Buying and selling options contracts can be risky and should be cautiously approached. But experienced traders can use options in various ways, including limiting potential losses.

All kinds of investors can access stock options with some of the best online brokerages and investment platforms.

Here are the basics of trading stock options, hedging strategies, and the risks involved with options contracts.

What are stock options?

A stock option is an agreement between two parties. When you purchase a stock option, you have the right — but not an obligation — to buy or sell a stock at a specific price within a certain period. If you're the option seller, you must fulfill the agreement based on the buyer's decision.

"Stock options allow you to benefit from a change in a company's stock in a heightened or leveraged manner," explains Yves-Marc Courtines, CFP and principal of Boundless Advice LLC. "The gain may be from an increase or decrease in the stock's price."

Terminology in stock options trading

Several key terms are important to discussing and understanding how options work:

Holders and writers: The option holder purchases the option, and the option writer sells the option.
Exercising an option: The holder exercises an option when buying or selling the stock.
Expiration date: The end of the potential purchase or sale period.
Premiums: The holder pays the writer a nonrefundable premium for the option. Its value can depend on the expiration date and the underlying stock's expected volatility.
Strike price (exercise price): The price at which the holder can buy or sell the stock at.
Time value: The time remaining until the potential purchase or sale period.
Intrinsic value: The difference between the current asset and strike prices.

Types of stock options

Different types of options contracts are traded and categorized in varying ways. The two main types of options are:

Call options: The holder can buy the underlying stock or other asset at the strike price before the expiration. Call options generally increase in value as the underlying asset's price rises. Long calls have unlimited upside potential, so investors use them to speculate on the underlying asset's price. The maximum loss potential is the initial premium.
Put option: The holder can sell the stock at the strike price by the expiration date. Put options increase in value as the price of the underlying asset falls. A long put is a shortened position on the underlying assets. Investors use put options to hedge against current holdings in their portfolios. This is referred to as protective puts.

You can buy or sell either type of option.

There are also differences between US and European options. In the US, the options holder (aka the buyer) can exercise the option at any time before the expiration date. European options can only be exercised on the expiration date.

How stock options work

You can buy or sell a specific number of shares of an underlying asset at the strike price on or before the expiration date. You're not obligated to trade the underlying asset in the event that you only want to buy or sell in more favorable market conditions.

Stock options provide investors with significant leverage since options are traded at a lower price than buying the stock outright. Plus, you'll get a larger position in that stock. If used correctly, options trading is an effective way of generating income from fluctuating stock prices. Options contracts are commonly used with stocks but can also be used for other assets such as bonds, commodities, and currencies.

"If you want to dip your toe in, you could write a covered call," says Morrison. "It means you own the stock, and you write a call, meaning you sell a call."

For example, you own 500 shares of company XYZ, which trades at $80 a share, and you sell five call option contracts — each contract is for 100 shares. You collect $1.20 in premiums per share and receive $600.

The holder has the right to purchase the 500 shares from you for $85 a share (the strike price) during the next six weeks. They may let the option expire if the stock's price never exceeds $85. But, if it does, the holder can exercise the option, and you'll lose out on potential gains. In either case, you get to keep the $600.

The role of options exchanges

Options exchanges are a crucial element of options trading. They are specialized marketplaces facilitating option trading and ensuring fair and regulated trading among buyers and sellers. Option exchanges assist in market liquidity and efficiency and help investors make more informed trades through the transparency of the exchange's publicly displayed order book.

Options exchanges are used by both individual investors and institutional investors like investment banks or hedge funds.

Some of the major options exchanges in the US include:

Chicago Board Options Exchange (CBOE)
Boston Options Exchange (BOA)
Miami International Securities Exchange (MIAX)
Nasdaq Options Market
NYSE American Options

Pricing of stock options

Stock options pricing is determined using the option's intrinsic and time values. Other factors that influence price are interest rates and volatility.

The intrinsic value is the difference between the stock price and the predetermined strike price to reflect the option's overall profitability. Time value represents the possibility that the stock price moves in your favor before its expiration date. Over time, the time value decays, and the option loses value as it expires.

More complex mathematical pricing models can also ensure an option's fair market value based on factors like interest rates, dividend yields, stock price, and volatility. One of the well-known pricing models is the Black Scholes model. However, this model does not take into account cash flow flexibility.

Pros and cons of stock options

Uses of stock options in investing

Stock options are often utilized as a hedging strategy to reduce risk and potential loss in your investment portfolio. Some hedging strategies using stock option include:

Protective puts: A common risk management strategy for investors buying put options to limit risk on an already owned asset. Similar to an insurance strategy, protective puts limit losses if the price of the underlying stock drastically falls. It's best when used in volatile markets or as a hedge against short-term declines.
Covered calls: Provides a short-term hedge against minor price shifts (up or down) while holding a long position in an underlying asset already bought by the investors. This strategy is best used by investors who predict that the underlying stock will remain nearly the same. However, you'll have to forfeit your stock gain if the asset's price exceeds the option's strike price.

Risks of trading stock options

Investing always involves risk, and options trading can be much riskier than buying and holding a company's stock.

"You can lose all the money you put in when you buy a stock," says Theresa Morrison, advisor at BlockSpaces. "If you buy or sell an option and you don't know what you're doing, you could lose the money, your car, and your house."

For buyers, there's a chance that the value of the underlying stock moves in the wrong direction, and they'll have to let the contract expire. A similar risk of investing in stock options can occur with wrong timing, as there is a chance that the underlying stock does move in the right direction, but not before the contract expires.

Investors can also use options to limit their potential losses. But you might not want to buy or sell options until you understand what you're getting into.

What are employee stock options?

Employee stock options are a type of employee equity compensation. Companies may offer options as part of a sign-on bonus or retention program.

To draw a comparison, Morrison says, "An employee stock option is always a call option because you have the right, but not the obligation, to buy the company's shares at a fixed price during a certain period of time."

Courtines points out that, unlike traded stock options, equity offers are granted rather than purchased. Still, there's some risk involved. "What you're giving up is a paycheck," says Courtines. "Instead, you're getting an option that could be worth more but that could also expire worthless."

You may also have to wait until an option vests before exercising it. For example, a portion of your option may vest each year during the first five years in a new job.

Common types of employee equity compensation

Companies can offer two types of stock options — incentive or non qualified.

Incentive stock options (ISOs): An ISO can offer tax advantages because your profits could be subject to the capital gains tax rate. But they can also trigger the alternative minimum tax (AMT).
Non qualified stock options (NSOs): Don't receive a special tax treatment. Your employer may automatically withhold income and payroll taxes. And you'll pay ordinary income taxes on the difference between the current fair market value and your exercise price.

Other common types of equity compensation also exist, but these aren't technically options.

Restricted stock units (RSUs): Companies may offer RSUs that you'll receive based on a vesting schedule or for meeting certain goals. "RSUs look more like a cash bonus," says Courtines, "and they've become the dominant form of incentive compensation."
Employee stock purchase plans (ESPPs): The company lets you buy its shares at a discount — often 5% to 15%.

What to ask if you're offered or have equity compensation

Equity compensation programs are a popular way for companies to attract and retain employees. Here are a few suggestions and points to consider if you're offered or receive equity compensation:

If you receive ISOs, Morrison suggests working with a professional to create an exercise strategy and five-year plan to account for the potential tax implications.
When working at a private company, you may want to hire a financial advisor to help determine the value of your options or equity.
If you receive RSUs in a private company, ask if a liquidation event, such as an IPO or merger, restricts them.
Accept the options or equity grant — it isn't always automatic.
You may need to exercise your options actively, or they might expire.

Also, consider how the equity impacts your entire financial position. For example, you may want to immediately sell shares from RSUs and ESPSs and use the proceeds to diversify your portfolio. Otherwise, your income and a large portion of your portfolio may depend on a single company's success.

Stock options FAQs

Do you need a special account to trade stock options? Chevron icon It indicates an expandable section or menu, or sometimes previous / next navigation options.

Not all brokerage accounts offer options trading, so you'll need to make sure that the brokerage account you open offers stock options as a feature. You may need to meet additional account requirements, like a higher minimum account balance or a premium subscription.

Can stock options be exercised at any time? Chevron icon It indicates an expandable section or menu, or sometimes previous / next navigation options.

It is possible to exercise stock options at any time, depending on the option style. For example, American options can be exercised any time before the expiration date. European options, on the other hand, can only be exercised at expiration.

What happens if options expire out-of-the-money? Chevron icon It indicates an expandable section or menu, or sometimes previous / next navigation options.

If options expire out-of-the-money, they essentially lose all value and are worthless. The buyer losses the premium paid for the option.

How can beginners learn to trade stock options? Chevron icon It indicates an expandable section or menu, or sometimes previous / next navigation options.

Learning stock options trading for beginners is best through educational resources like online courses, reference articles and guides, and attending workshops or webinars. To see a theoretical scenario play out, beginners can also practice using paper trading accounts.

Are stock options only available for stocks? Chevron icon It indicates an expandable section or menu, or sometimes previous / next navigation options.

Stock options specifically refer to options tied to stocks. However, options trading also applies to other assets, such as bonds, indexes, ETFs, commodities, and currencies.

Louis DeNicola

Louis DeNicola is the president of LD Money Media LLC and an experienced writer who specializes in consumer credit, personal finance, and small-business finance. He is a Nav-certified credit and lending specialist, a multi-year attendee of an 18-hour advanced credit education seminar, and a volunteer tax preparer through the IRS's VITA program. Louis works with various publishers, credit bureaus, Fortune 500 financial services firms, and FinTech startups. In addition to Insider, you can find his work on Experian, FICO, Credit Karma, FICO, and Lending Tree. You can connect with Louis on LinkedIn or reach out to him directly at ladenicola@gmail.com.