Common Stock Options: Everything You Need to Know
Common stock options are options to purchase stock at a later date in time and the option to buy usually has an expiration date of 30-90 days in the future.3 min read
Common stock options are merely options to purchase stock at a later date in time. Specifically, options are those sold by one party to another party that allow the potential purchaser to exercise the right to buy the options at a previously agreed price. The option to buy usually has an expiration date of 30-90 days in the future.
There are different types of options that can be used, including the following:
- Puts and calls
- Writing options
- Employee stock options
A call occurs when someone has an option to purchase shares at a certain price before the option to purchase expires. A put occurs when the buyer can sell stock at a certain price before the expiry date.
With regard to a call option, the purchaser assumes that the stock will increase in price, while the seller of the stock assumes that the stock will actually decrease. Therefore, the seller wants to make money on the call option by selling it at what he thinks is a higher price since he believes the stock will decrease. The buyer, however, believes that the stock will continue to increase, and will therefore think he is getting a great deal on purchasing the stock at the agreed upon price identified in the call option.
For example, let’s assume that ABC Company stock is selling at $100 per share. If the strike price (the option price) is $95, the trader will initially buy the option for $8. Thereafter, during the time when the option is open, the stock raises to $105. In this case, the trader will make a net profit of $2 based on the difference between the prior stock price of $95, the new stock price of $105, and the amount the trader paid for the initial option, which was $8. The most the trader can lose out on any options contract would be the amount he or she paid for the initial option. In this case, it would be $8.
If the trader believes the stock will reduce in value, he can purchase a put option giving him the right to sell the stock at the strike price before it expires. If the stock does in fact reduce in value, the trader will earn a profit. An example of this would be if the strike price is $50, but the trader pays $3 for the initial option. If the stock falls to $45 by the expiration date, the trader will then earn a net profit of $2 for each share. This might be quite substantial depending on how many shares are involved in the initial option contract.
Keep in mind that the more volatile the stock is, the greater the cost of the option for the trader.
Some traders might want to buy options whereas others might have to write them. The writer of the actual option contract receives a premium for writing the option. This is the maximum profit that can be made on the option. But the writer assumes the risk of having to buy or sell the shares from the buyer at the strike price. This could be a big loss for the writer. For example, if a trader writes a call option, the option buyer can purchase the option at the strike price. Let’s assume that the strike price is $5, but the price of the stock increases to $30. The writer still has to provide the option buyer with the option to purchase the shares at $5. This means that if the option is exercised before the expiration date, the buyer will significantly benefit, and the writer (the trader) will have suffer a financial loss.
Employee Stock Options
Employee stock options are similar to that of a call or put option. The differences are in that the employee stock options usually vest at a certain point in time, rather than expire. This means that the stock options will mature at which point the employee will have full ownership over the shares and not have to return them or lose their ownership rights upon leaving the company. For example, some companies might require that an employee work for the company for a period of at least 3-5 years before vesting. If the employee leaves before the vesting date, they will lose their ownership rights over the stock.
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