Stock options are a popular investment tool for securities traders and for corporations who use them as a way of rewarding executives and senior employees. A stock option provides a way of leveraging stock transactions and can be extremely profitable. Although there are important differences between employee stock options and those traded on the market, both fit the definition of stock options.

A stock option gives you the right to buy (or sell) a specified number of shares of a stock (referred to as the underlying security) at a set price for a limited time period. However, you are not obligated to use the option. In the United States options are usually for lots of 100 shares of the underlying security. The option can be to either buy the stock (a call option) or to sell it (a put option.)

History

The stock option dates back to 1872 when it was first introduced by financial entrepreneur Russell Sage. Trading stock options were done over the counter for more than a century. Stock options for high-ranking corporate employees emerged in the late 1800s as an incentive/benefit method. A company would offer an employee the opportunity to buy company stock at bargain prices for a set period of time. Modern options trading dates from 1973 with the opening of the Chicago Board of Options Exchange, and by 1976 the American Stock Exchange and several others had opened similar options exchanges. The advent of listed options trading with standardized contracts opened this financial vehicle to the investing public and made options trading a major feature of the financial scene.

Types

Stock options traded on exchanges (called listed options) are purchased through brokers like shares of stock. Listed options follow a standardized contract sold by an individual or institutional marketers called market makers. The most popular option type is the long-term equity anticipation security or LEAPS™. A LEAPS is usually written for nine months or longer. Beginning in 2006 another type, the quarterly option, has become popular. Quarterly options are issued at the start of each calendar quarter and expire at its end. Flex options and exotic options are non-standard options usually traded over the counter and include customized features in the contract. Employee stock options vary in their terms and features, are issued by individual corporations and are not traded on the options market.

Function

If you purchase an option to buy shares of a stock at a given price, the price includes two components. One is a premium of a few cents per share (called the extrinsic value) and is the margin the market maker adds for their services. The other (the intrinsic value) is the difference between the option price and the price of the underlying security. For example, if the you buy a call option at $30 per share, and the current stock price is $32 per share, the option price will be around $2.50 (the $2 per share price difference plus the extrinsic value). If the stock then rises to $40 per share, the option price rises to $10.50, and you’ve quadrupled your investment. Put options work the same except that you have the right to sell at a specified price and if the stock price falls you make a profit.

Considerations

The potential for very high profits makes options a favorite among speculators and hedge traders. However, it is a very high risk form of trading. The biggest risk is that if the option reaches its expiration date before it is “in the money” it becomes worthless and you lose all of your money. The key to successful options trading is to remember that it’s the price of the underlying security that determines the value of the option. You should research any company very carefully and have a clear idea of its current status, stock trading patterns and future prospects before purchasing options on the stock.

Advertisement