Options
Stock options are a form of equity compensation that gives the investor the right, but not the obligation, to buy or sell a stock at an agreed-upon price and date. Stock options are a common form of equity derivative. One equity options contract generally represents 100 shares of the underlying stock.
Options are contracts that give you the right (but not the obligation) to buy or sell an underlying asset at a predetermined price before a certain date. There are two types of options: call options and put options. Call options give you the right to buy the asset, while put options give you the right to sell it.
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There are three ways to buy options
- Hold until maturity, this means that you keep your options contracts until the end of the contract period, before they expire, and then exercise them at the strike price (the predetermined price).
- Trade before the expiration date, this means that you sell your options contracts to someone else before they expire, either for a profit or a loss.
- Let the option expire, this means that you do nothing with your options contracts and let them expire worthless.
To buy options you'll need a trading account
To buy options, you need to open an options trading account with a broker (Webull - Robinhood) that offers this service. You also need to complete some qualifications and demonstrate that you understand the risks and strategies involved in options trading. Then, you can select the stock or other asset that you want to trade options on, choose an expiration date and a strike price, decide how many contracts you want to buy, and place your order.
There are two primary types of options contracts, calls and puts.
A call option gives the buyer the right to buy a stock at a specified price (called the strike price) before a specified date (called the expiration date). A call option is a bet that a stock will rise in value.
A put option gives the buyer the right to sell a stock at a specified price before a specified date. A put option is a bet that a stock will fall in value.
The seller (or writer) of an option contract receives a premium (or fee) from the buyer for granting this right. The seller has an obligation to fulfill the contract if the buyer exercises their right.
Stock options can be used for various purposes, such as hedging, speculation, income generation or employee compensation.
There are several factors that affect the value of stock options.
Value of the underlying asset
The value of the underlying asset has a significant effect on the value of an options contract. The value of a call option goes up with a higher underlying price, while the value of a put option goes down with a higher underlying price.
Exercise price
The exercise price is the price at which the option holder can buy or sell the underlying asset. The value of a call option goes up with a lower exercise price, while the value of a put option goes up with a higher exercise price.
Expiration time
The expiration time is the date when the option contract expires and becomes worthless. The value of an option decreases as it approaches its expiration date, because there is less time for the underlying asset to move in favor of the option holder.
Risk-free rate of interest
The risk-free rate of interest is the interest rate that can be earned on a risk-free investment, such as government bonds. The value of an option is affected by changes in interest rates, because they influence the present value of future cash flows and opportunity costs. Generally, higher interest rates increase the value of call options and decrease the value of put options.
Volatility
The volatility is a measure of how much the underlying asset fluctuates in price over time. Higher volatility increases the value of both call and put options, because it implies greater uncertainty and potential for large price movements in either direction.
Underlying and cost to carry
These factors refer to any dividends or distributions paid by the underlying asset, and any costs associated with holding or borrowing it. These factors affect the cash flows and opportunity costs associated with owning or shorting an option contract. Generally, higher payments on the underlying decrease the value of call options and increase the value of put options, while higher costs to carry on increase the value of call options and decrease the value of put options.
Option premium
The cost of buying an option is also called the option premium. It is determined by several factors, such as the price of the underlying asset, the strike price, the expiration date, the volatility of the asset, and the interest rate. The option premium consists of two components: intrinsic value and extrinsic value.
Intrinsic value is the difference between the current price of the underlying asset and the strike price of the option. It represents how much money you would make if you exercised the option right now. For example, if you have a call option to buy GE shares at $30 and GE is trading at $34.80, then your option has an intrinsic value of $4.80 ($34.80 - $30 = $4.80).
Extrinsic value is the amount of money that you pay for the possibility that the option will increase in value before it expires. It depends on factors such as time to expiration, volatility, and interest rate. For example, if your GE call option has a premium of $5 and an intrinsic value of $4.80, then your extrinsic value is $0.20 ($5 - $4.80 = $0.20).
The cost of buying an option varies depending on supply and demand in the market. You can use an options pricing model or formula to estimate how much an option should cost based on its parameters.
Comparing option prices
There are different ways to compare options prices depending on your purpose and preference. One way is to use an option pricing model or formula that estimates how much an option should cost based on its parameters, such as the underlying asset price, strike price, expiration date, volatility, interest rate, and dividends. Some common option pricing models are the Black-Scholes model, the binomial model, and the Monte Carlo simulation. You can use these models to compare options prices across different scenarios or assumptions.
Another way is to use a comparison shopping engine (CSE) that allows you to compare pricing, shipping options, and provided services from multiple retailers on a single webpage. Some examples of CSEs are Google Shopping, PriceGrabber, and Shopzilla. You can use these tools to compare options prices across different sellers or platforms.
A third way is to use a website or a tool that displays real-time or historical options prices for various securities. For example, you can use Barchart.com to see today's stock option quotes and volatility, or MarketXLS to get real-time options pricing in Excel sheets. You can use these resources to compare options prices across different symbols or contracts.
A fourth way is to use a broker or a platform that offers competitive and transparent options trading fees. For example, you can use Interactive Brokers to trade options with a $0.65 charge per contract and no base fee, or E*TRADE to trade options with no commission but a $0.65/contract fee (discounted for larger volumes). You can use these services to compare options prices across different brokers or platforms.
Some of the advantages and disadvantages of stock options
Advantages
Stock options can increase company loyalty, as employees who buy shares of stock in a company might be more committed to the company's success.
Stock options can allow companies to grow without having to pay extra taxes, as they can use stock options as a form of compensation instead of cash.
Stock options can offer tax benefits for employees, as they may be able to defer or reduce their tax liabilities depending on the type and timing of their stock option exercise.
Stock options can require a lower upfront financial commitment than stock trading, as the price of buying an option is usually much lower than buying the underlying stock outright.
Stock options can provide leverage and flexibility, as they can amplify returns and losses with relatively small price movements, and allow investors to tailor their risk-reward profiles according to their market views.
Disadvantages
Stock options can have lower liquidity than stocks, as many individual stock options may not have much volume or open interest, making it harder to buy or sell them at favorable prices.
Stock options can have higher complexity and volatility than stocks, as they are affected by multiple factors such as time decay, implied volatility and dividends that may change rapidly and unpredictably.
Stock options can result in financial risks for both employees and companies. Employees may lose money if the stock value plummets or if they fail to exercise their options before expiration. Companies may face dilution or increased costs if employees exercise their options and demand more shares of stock.
Stock options can create misalignment of incentives or moral hazards for executives or managers. They may pursue short-term gains or take excessive risks at the expense of long-term value creation or stakeholder interests.