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What is a Stock Option?

What is a Stock Option?

Understanding stock options is an important piece of knowledge for any employee or investor to have. To find out more, keep reading here.

11th September 2019

A stock option for investors differs from an employee stock option. This guide will explore both puts and calls as well as their differences to an employee stock option.

Stock Options

A stock option provides an investor with the right but not obligation to buy or sell a stock at an agreed price. There are two types of options:

Puts: A contract which gives the owner the right to sell a specific volume of an underlying security. This security will be sold at a pre-determined price (strike price) within a specific time frame (time to maturity). Put options can be traded on numerous underlying assets. The most common is stocks, however currencies, commodities and indexes can all be underlying assets for option contracts. A put option becomes more valuable as the price of the underlying assets falls relative to the strike price. This fundamentally means the investor believes the stock or underlying asset will fall in price.

Call: A contract which gives the owner the right to buy a specific volume of an underlying security. The characteristics of a call are similar to that of a put option. However, the critical difference is that the investor believes the underlying asset will increase in price.

Example

An investor purchases a put option on the Commonwealth Bank of Australia (CBA) with a strike price of $80 expiring in three months. For this option, the investor paid a premium of $300, ($3 x 100 shares). This means the investor has the right but not obligation to sell the contract at $80 within three months.

In one month, the CBA stock falls in price to $70. If the investor exercises the option contract they are able to purchase the stock at $70 and sell the shares to the option writer for $80 each. Consequently the investor would make $1000, (100 x (80-70)). Minus the premium of $300 and any commissions, the net profit would be $700.

A call or put option can be purchased through the ASX.

Employee Stock Option

An employee stock option is a form of equitable compensation given by companies for employees. Instead of offering shares of a stock directly, the company offers derivative options on the stock. This gives the employee a call option, meaning they have the right to buy the company’s stock at a specific price within a set time period. An employee stock options agreement will detail specific terms for the employee. Subsequently, it is important to speak to an employment lawyer to make sure you understand the terms of your stock option agreement.

Typically, an employee stock option is beneficial if a company’s stock rises above the exercise price. When a stock price rises above the exercise price and the employee exercises the call option the employee obtains the company’s stock at a discount. The employee can then sell the stock in the market for a profit or hold the stock.

Conclusion

Stock options can be puts (sell) or calls (buy) for an underlying asset. While these contracts can be highly rewarding they are also high risk. Comparatively, an employee stock option offers an employee a derivative on the company’s stock. This enables the holder to later obtain the stock at a discount and make a profit through trade on the open market. If you are interested in creating an ESO it is advisable to create an employment share scheme offer.

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Author
Gopi Giri

Gopi currently works in the content team as a Legal Intern for Lawpath. He is in his fourth year of a Bachelor of Law and Commerce (Accounting) at Macquarie University. Gopi is interested in cyber law and future innovations in the legal industry.