Stock Options Explained

Considering stocks or stock options? Wondering what the difference is? Well, stock options can help you generate more profit than stocks alone. 💰

And more people are recognizing this advantage. The CBOE reported a record option volume increase of 18.4 million contracts a day in August 2020. This was a year-to-date increase of around 80%. This month so far, stock options activity continues to rise, with single-stock option volume averaging 23.8 million contracts a day, up to Sept. 8th.

Stock options do not restrict you to buying, selling, or staying out of the market. They give you more flexibility: options give you, well… options. 

Furthermore, employee stock options (ESOs) are in fashion because of the positive benefits they offer both employees and businesses. In some cases, generating returns in the six figures. How can you get the most out of your ESOs?

There are some good examples out there, if you want to know how ESOs are done properly, then take a look at Valtech Valuation’s efficient system.

In this guide, we will explain what stock options are, and the specific terms you need to know. We’ll also discuss just how much you could potentially earn over time with ESOs, and which crucial mistakes to avoid.

What is a Stock Option? 🤔

A stock option gives investors the right, or the option, to buy or sell the underlying stock for an agreed price at a specific date. So, why would anyone invest in a derivative investment instead of the underlying security that its value is based on? 

To put it bluntly, stocks and options are fundamentally different. The payoff for a stock option is not equal to the payoff offered by stock. Stock options follow a more complex payoff pattern.

If used correctly, they can fundamentally change your investment. In simple terms, they can be thought of as a bet between two investors over which direction a particular investment is going to move. As bets go, one investor ends up paying the other depending on the direction the stock moves.

There are two kinds of options: A put option, which is a bet that a stock will fall, and a call option, which is a bet that a stock will rise.

Stock options can be traded on exchanges in the same way that stocks are. Options can be priced more or less than the initial price when it was originally listed. Most options listed in the U.S. comply with an options calendar and generally expire on the third Friday of the month that they are set to expire.

Before the expiration date, the owner of the option will need to either exercise the option by selling the option, by buying or selling the agreed amount of shares associated with the option, or letting it expire.

In addition to stock options listed on exchanges, many companies offer employee stock options as a form of incentive compensation. These are stock options that allow the employee to buy a set amount of shares in the company at a specific rate for a set period of time. 

Benefits of Stock Options 🤗

• ☑️ Flexibility
• ☑️ Efficient, Orderly, and Liquid Markets 
• ☑️ Limited Risk
• ☑️ Guaranteed Contract Performance

Above we have highlighted the key benefits of options traded on exchanges. Although options have a long history, expanding several centuries, it was only in 1973 that standardized, government-regulated options became available. In just a few years, options virtually displaced the limited trading in over-the-counter options, becoming an indispensable tool in the securities industry.

How Do Stock Options Work?

We break down the functionality of options as follows: The price of an option listed on an exchange is connected to the price movement of the underlying stock. If this rises or falls, the option will mostly sail along in the same way. This flexibility is key in a volatile market.

To start, let’s go through a few key terms you’ll need to nail down before we go any further into options:

Call & Put Options 🔎

A call option gives the holder of the option the right to buy a stock for a certain price within an agreed upon time frame.

Then you have a put option. This gives the buyer the right to sell shares in the stock for a certain price within an agreed-upon time frame.

American and European Stock Options 🌎

There are two styles of options, American and European, both of which work differently. American options can be exercised at any stage from the date of purchase to the date of expiration. European options, on the other hand, are not as common, and can only be exercised on the date of expiration.

Strike Price ⚡️

The strike price is the agreed-upon transaction price, and the profitability of a stock option will depend on the options strike price and the current market price at the time of expiration. For example, if you think the stock will rise to $100, and you have a call option for $85, you could make $15 by exercising your call option.

Premium 💰

Then we should note down the premium. This is the amount that the option buyer will pay for the option. This figure represents the maximum profit that can be realized by the seller. Selling the option can be thought of in the same way as selling a stock.

In differing from stocks, options are traded as a contract, and one contract covers 100 shares of the underlying stock. The option buyer or option seller will receive or pay the premium in two parts, both of which have an affect on the premium:

1. The intrinsic value: This is the difference between the options strike price and the current market price of the underlying stock.
2. Time: The expiry date and the level of volatility experienced by the underlying stock for the time the option is held.

In the Money & Out of the Money 💵

When you have a call option with a strike price higher than the market price of a stock it’s known as being “in the money”. And when you have a call option with a strike price that is higher than the stock price it’s known as being “out of the money.”

Bid & Ask Price 🤝

Lastly for options terms, you’ll need to know the bid and ask price. The bid price is the amount the buyer would like to pay for the option. The ask price is the amount that the option buyer is looking to sell the option for.

Expiration Date 📅

Options allow traders to bet on whether a stock will rise or fall, in addition to allowing the trader to choose a date they think the stock will rise and fall by. The date set is the expiration date of the option. 

This is important because it helps traders get a reading on the value of the put and call, known as the time value. This method is used by a variety of option pricing models like the Black Schole Model.

Contracts 📝

Contracts for stock options display the amount of options a trader might want to purchase. One contract allows traders to buy 100 shares in the stock. Using our example above, say you want to buy five call contracts.

In this case, you would become the owner of five March $200 calls. If the stock increases more than $200 by March, you can choose whether you want to exercise the option to buy the agreed amount of shares at $200, despite whatever the stocks are priced at, at that time. 

If the stock falls below $200 then you won’t get much use out of it because you could buy them for less. The option will simply expire, and you’ll lose the amount you paid for the options, called the premium.

Trading Options ✅

Depending on the strategy the trade is using, options can be traded, too. Again, taking our example above, if the Tesla shares are expected to rise, you could buy the call, or the put can be sold. 

In this case, you would receive the premium instead of paying it. The seller of 5 Tesla March $200 shares would receive $1,000.

If the stock goes beyond $200, the option will expire and the seller can retain the premium. This would mean a loss of not just the premium but any additional capital too.

Example of a Stock Option 📈

In an example, we can graph how the total return will be affected by the movement in the price of the underlying stock. Let’s say, for example, that you buy stock in Nvidia Corp’s (NVDA). Let’s say you pay $30 per share. Any dollar increase in the stock price is a dollar added to your return. If the price doesn’t change, then you make $0. 

Now let’s consider a call for a share of NVDA. If you bet a call with the following figures: 

• ☑️ Call Option
• ☑️ Premium: $2
• ☑️ Strike: $30
• ☑️ Expiration: 6 months

In this case, you are already starting below the $0 mark because you paid a $2 premium. This makes call options riskier. If the market price of the stock drops below the strike price, known as being out of the money, the most you can lose is the premium.

This is because the option doesn’t need to be exercised if you won’t earn a profit from it. If the stock price falls, the contract will simply expire.

Puts work in a similar way, but since they give the right to sell, the graph above would be flipped. If the stock price falls below the strike price, you can buy a share at a lower market price, and exercise the put to sell the share at the higher strike price, making a profit and limiting downside risk of just $2 (acting as a kind of insurance).

But this is just the tip of the ice-berg when it comes to popular strategies for options trading. While options can help hedge risk, they can also be used to increase the risk of your holdings, too. 

So far we’ve only mentioned buying options, or going-long, but you can also sell, or go short. If you believe a stock’s price will remain stable, or move in a certain direction, you can sell the option that you believe will expire worthless, and earn the premium, making a small return. 

The catch with shorting is there is a limited upside and a larger potential downside. Call options pose unlimited losses. This is because, in theory, a stock’s price could potentially rise to infinity.

Employee Stock Options 💸

Employee stock options (ESOs), are stock options in the company’s stock granted by some companies to employees. Though employee stock options are trending because of the positive benefits offered, the risks associated with ESOs have arisen in recent years.

In addition, the media are beginning to question whether ESOs are being taken advantage of for profits by managers and shareholders in the company.

In our opinion, it is possible to use ESOs entirely for profit. Though they should be used reasonably and logically to avoid becoming the cause of contention among company shareholders.

Key Concepts of Employee Stock Options ⭐️

Here’s some of the key vocabulary surrounding employee stock options:

1. The grant date is the date the employee is granted the option.
2. The vesting schedule is the time table that the employees gain control over the options. This varies from company to company. The options may best all together or gradually over time, say 25% per year over ten years.
3. Traders can only exercise the vested portion. Generally, if you leave a company the vesting stops. Provisions might be in place regarding when the vested options need to be exercised.

Deciding whether to exercise the option is not too dissimilar from options traders. If the price of the underlying stock rises above the strike price then you can make a profit by exercising the option. If it falls below the strike price, on the other hand, then it doesn’t make sense. 

There are two main varieties of employee stock options, non-qualified and incentive stock options, both of which are taxed differently.

Non-Qualified Stock Options 💳

Non-qualified stock options are taxed as ordinary income the year that the options are exercised. You will pay the difference between the price of the stock at the time they are exercised and the strike price.

Once the options are exercised (so long as they are held for a minimum of one year and one day), then any gain post-exercise will be taxed at long-term capital gains rates, which are more favorable.

Incentive Stock Options 🪙

Incentive stock options are a little more complex when it comes to tax. Employees could be liable for capital gains, ordinary income taxes, and minimum tax in a variety of combinations.

Real-Life Example of Employee Stock Options

Now let’s consider that an employee is given the option to buy 2,000 shares of an employer’s stock for a strike price of $100 per share. The options can’t be exercised until they are vested, and the employee will not own the shares until the vesting period requirement has been met.

The employee might set up a multi-year vesting schedule which means that the employee could vest 400 shares each year, over five years, for example. In this case, the employee would be vested in 400 shares in year one, and 800 in year two, up until it reaches 2,000 shares.

The employee can exercise the options each year. So, they can buy, then sell the stock. This option is only valid if the market price goes beyond $100 per share.

If it reaches $150 in year one, for example the employee could buy 400 shares for $40,000 then sell them on and make $60,000, making a cool $20,000 in profit. If the market price stayed at $150 per share of the course of five years, the employee would make $100,000. 

For this reason, speculative trading has had a major ramp up. Sharks in the market, like SoftBank, who bought call options on $50 billion worth of technology stock, is now up $4 billion, a move which helped propel the U.S. stock market to record highs. Smaller traders are now the majority of the options market. 

Stock Options vs. Restricted Stock Units ⚖️

Another form of stock-based compensation that companies can use are restricted stock units (RSU).

Restricted stock units are a grant of a certain number of shares in a company. The stock is taxed when the shares are received. How much they are taxed by depends on the market price of the shares at the time they are received.

Typically, RSUs have a vesting schedule, if you happen to leave the company, the schedule stops.

RSUs nearly always hold a value of some sort, unlike employee stock options. Even if stock falls after you get the RSU, it will be valued based on the market price of the stock at the time of vesting. Stock options are essentially worthless if the market value of the stock falls below the strike price.

With RSUs you’re given the shares of a stock, with the requirement to buy the shares. There are some differences when it comes to stock, too: The value of RSU shares is taken as income and tax is paid at the time of the grant.

You also might be charged capital gains taxes once you sell the shares. Whether this is long-term or short-term will depend on the holding period.

What to Do if You’re Granted Employee Stock Options 💲

As we mentioned above, risks associated with employee stock options have risen in recent years. If you recently received employee stock options, or RSUs, here are some points to consider:

Carefully Read the Agreement on the Option 🔎

You should have a strong understanding of everything within your options agreement. This is both an investment option and compensation, make sure you know the liable taxes, in addition to the details of exercising the option. A financial consultant or tax professional can offer help if needed. 

Have a Financial Plan 📝

Make sure that this option grant and the underlying shares fit in your financial plan and your investment strategy overall. When exercising the option, think about whether these shares will result in an over allocation of your company’s stock. 

Holding a concentrated stock position in a stock can carry risks, especially when it comes to your employer’s stock. Say the company fell into some financial difficulties, the stock might drop, biting into a big portion of your net worth.

Stick To Your Investing Strategy ✅

You will benefit from having a strategy for buying, holding and selling the stock within your plan. Be aware that public companies have individual trading windows in which employees must buy or sell the stock within.

You should also do a bit of tax planning, taking into consideration the options. These suggestions should help you get the most value from your ESOPs.

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