Stock Options Explained in Plain English

Stock Options Explained in Plain English

Stock options explained in simple terms are financial instruments that let you buy or sell a specific stock at a specific price at a specific time. You can buy and sell them through a brokerage, provided your account is approved for options trading, but keep in mind that options trading can be risky depending on the transactions you make. You may also receive or be able to buy stock options through your employer as part of your compensation.

Stock Options Explained

Stock options are a special type of market instrument that give you the right, or quite literally the option, to buy or sell a stock at a particular price at a particular time. That price is known as the strike price. How long you have to take advantage of, or exercise, a stock option depends on the terms of the option. Options can be written around assets other than stocks, such as commodities like grain or metals or even the value of stock market indexes, but the principles work effectively the same way.

Traditionally, ones called European options allow you to exercise an option only when it reaches its maturity, while American options can be exercised at any time up to that point. A capped option is one that automatically gets exercised if the stock price hits a certain level and effectively caps how much you can make from the option's exercise. Make sure you understand when you can exercise options and how to do so, so that you don't miss your chance or anticipate making money on a transaction that's not allowed.

Put and Call Options

Options that let you buy a stock are known as call options because they let you call for delivery of the stock at the strike price. Those that let you sell the stock at a certain price are commonly known as put options.

Call options rise in value if it is more likely that the stock price will exceed the strike price when they're set to be exercised, since you can therefore by the stock at a bargain price. On the other hand, put options rise in value when the stock price is more likely to be lower than the stock price, since they will allow whoever holds them to sell the stock for more than it could fetch on the open market.

Trading in Stock Options

You can buy and sell stock options through many traditional stock brokerage firms, including modern online brokerages. Most will provide instructions on how to do so, so see options explained on Robinhood, Fidelity, Charles Schwab or any other brokerage of your choice to understand your choices.

Under Securities and Exchange Commission rules, you must file an application with your brokerage before you can begin trading in options. This application will generally specify information about your finances, including your income and net worth, what types of options you are looking to trade, your previous trading experience and your investment goals. Your brokerage will decide if you're eligible to trade options and will likely assign you to a risk category that may limit what types of options transactions you may enter into.

Work with your broker to understand what options transactions are available to you and right for you. Naturally, you'll want to also understand the details of any options you buy and sell, such as the strike prices, when you can exercise them and any other details. You'll also want to know about the underlying stocks and have a good sense of whether prices are likely to go up or down so that you can decide whether the option is a good deal for you.

Note that some options are always or sometimes cash-settled, meaning that you will receive the difference between the stock price and the strike price if you make money on the option rather than buying or selling actual stock. This is especially common with options based on commodities or stock market indexes rather than stock itself. Make sure you understand how your options are due to be settled.

Are You In the Money?

You may hear or read of the concepts of an option being in, out of or at the money.

An option that is said to be "in the money" is one that is set to make money based on current stock prices, meaning a call option is in the money when the stock price exceeds the strike price and a put option is in the money when the stock price is below the strike price.

An option is sometimes said to be "at the money" when the stock price is equal to the strike price.

Writing Options and Risks

If you buy and sell options where someone else is pledging to deliver or buy the security, you run the risk of losing your investment. After all, if the exercise date comes and the option is out of the money, it is effectively valueless.

You can also create, or write, and sell your own options, giving else someone the right to buy a stock from you or sell it to you at the strike price you agree upon. Writing a call option for a stock you don't actually own is called writing an uncovered, or naked, call.

Writing options is often riskier than buying them, because you can be on the hook for arbitrary amounts of money if your bet on the direction the stock is headed is wrong. Consider writing an uncovered call option allowing someone to buy a particular stock at $50. If the stock price rises to $200, you will be on the hook for the $150 difference, and if it rises to $500, you will effectively owe $450 to cover the option or buy and deliver the stock.

Similarly, if you write a put option at $50 and the stock price drops to $10, you will have to buy stock that is only worth $10 on the market at $50.

Make sure you understand your risks and your broker's requirements if you decide to write options.

Understanding Employee Stock Options

Employee stock options give a company's employees the right to buy stock at a certain price on a certain date, usually based on the price when they started working at the business. They are call options, but unlike exchange-traded options, you generally cannot sell them.

If you join a company and the stock price goes up, stock options will let you buy the stock at a bargain price. You're generally taxed on the price difference between the strike price and the market price when you exercise the option, since that discount is effectively compensation from your employer.

Employee Stock Options and Taxes

Some employee stock options are legally known as incentive stock options, and they allow you to pay income tax at the long-term capital gains rate rather than the ordinary income tax rate. That usually will save you money. Employee stock options that don't meet the legal requirements for that are known as non-qualified stock options.

Make sure you understand how your stock options work, including the potential tax treatment under various circumstances. Work with an accountant or financial advisor if necessary, and have a plan for how you will pay any taxes due when you exercise your options.