Stock option

A stock option is a financial contract that gives the holder the right, but not the obligation, to buy or sell a specific number of shares at a predetermined price within a set time period.
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Updated on Jun 6, 2024
Reading time 4 minutes

3 key takeaways

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  • Stock options provide the right to buy or sell shares at a fixed price before the expiration date.
  • They are used as investment tools and employee incentives.
  • Stock options can offer significant profit potential but also come with risks.

What is a stock option?

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A stock option is a financial derivative that represents a contract between two parties. The buyer of the option gains the right, but not the obligation, to purchase (call option) or sell (put option) a specific quantity of an underlying stock at a predetermined price (the strike price) within a specified period. The seller of the option, in turn, has the obligation to sell or buy the stock if the buyer exercises the option.

How stock options work

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Stock options have several key components that determine their value and functionality:

  • Strike price: The predetermined price at which the option holder can buy or sell the underlying stock.
  • Expiration date: The date by which the option must be exercised or it will expire worthless.
  • Premium: The price paid by the buyer to the seller for the option contract. The premium is influenced by factors such as the underlying stock price, strike price, time to expiration, volatility, and interest rates.

For example, consider an investor who buys a call option for Company XYZ’s stock with a strike price of $50 and an expiration date three months from now.

If XYZ’s stock price rises to $60 before the option expires, the investor can exercise the option to buy the stock at $50, gaining a profit of $10 per share (minus the premium paid). If the stock price remains below $50, the investor may choose not to exercise the option, limiting the loss to the premium paid.

Types of stock options

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There are two primary types of stock options:

  • Call options: These give the holder the right to buy a stock at a specific price within a certain timeframe. Investors purchase call options when they anticipate the price of the underlying stock will rise.
  • Put options: These give the holder the right to sell a stock at a specific price within a certain timeframe. Investors purchase put options when they anticipate the price of the underlying stock will fall.

Uses of stock options

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Stock options serve multiple purposes in both financial markets and corporate settings. In financial markets, investors use stock options to speculate on future stock price movements, hedge against potential losses, and generate income through option writing.

In corporate settings, companies offer stock options as part of employee compensation packages, providing incentives for employees to contribute to the company’s success. Stock options align employees’ interests with shareholders’ interests, as employees benefit when the company’s stock price increases.

Benefits and risks of stock options

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Stock options offer significant profit potential but also come with risks:

Benefits:

  • Leverage: Options allow investors to control a larger position with a smaller initial investment, amplifying potential returns.
  • Flexibility: Options can be used in various strategies to profit from different market conditions, including bull, bear, and sideways markets.
  • Risk management: Investors can use options to hedge against potential losses in their stock portfolios.

Risks:

  • Complexity: Options can be complex financial instruments requiring a good understanding of their mechanics and risks.
  • Potential loss: The premium paid for an option can be lost if the market does not move as anticipated, leading to the option expiring worthless.
  • Time sensitivity: Options have a limited lifespan, and their value diminishes as the expiration date approaches.

Stock options are versatile financial instruments used for investment strategies and employee compensation. They offer the potential for significant profits and risk management but also come with inherent risks and complexities. Understanding how stock options work and their appropriate use can help investors and companies make informed decisions to achieve their financial and strategic goals.


Sources & references

Arti

Arti

AI Financial Assistant

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Arti is a specialized AI Financial Assistant at Invezz, created to support the editorial team. He leverages both AI and the Invezz.com knowledge base, understands over 100,000 Invezz related data points, has read every piece of research, news and guidance we\'ve ever produced, and is trained to never make up new...