Stock Option

A stock option lets you buy or sell a stock at a set price on a specific date. There are two types: call options (betting on a price rise) and put options (betting on a price drop).
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What is a Stock Option?
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3 mins
25 November 2024

A stock option (also known as an equity option) gives an investor the right, but not the obligation, to buy or sell a stock at an agreed-upon price and date. There are two types of options: puts, which is a bet that a stock will fall, or calls, which is a bet that a stock will rise.

Because it has shares of stock (or a stock index) as its underlying asset, a stock option is a form of equity derivative and may be called an equity option.

Employee stock options (ESOs) are a type of equity compensation given by companies to some employees or executives that effectively amount to call options. These differ from listed equity options on stocks that trade in the market, as they are restricted to a particular corporation issuing them to their own employees.

What is Stock Option?

Stock options are a type of alternative pay offered by some companies, especially many startups, as part of their employee benefits package. Employees join at a lower-than-average salary in exchange for the possibility of a large payout later on. If you have been given options as part of a compensation package, make sure you understand how they work before exercising and selling them. A financial advisor could help you develop a financial strategy for your stock options or other investments.

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How it works

Here is how employee stock options typically work:

  1. Granting of options: Employees are granted stock options, which give them the opportunity to buy company shares at a specified price.
  2. Vesting period: Stock options often come with a vesting period, during which employees must remain with the company for a certain duration to be eligible to exercise (buy) the options.
  3. Exercise price: The exercise price is the predetermined price at which employees can buy the company's stock when they choose to exercise their options.
  4. Expiration date: Stock options have an expiration date. Employees must exercise their options before this date; otherwise, they become worthless.
  5. Potential for profit: The value of stock options increases if the company's stock price rises above the exercise price. Employees can then buy the shares at the lower exercise price and sell them at the higher market price for a profit.

Types of stock option plan

Stock option plans come in various forms, each tailored to meet the different needs and objectives of both companies and employees. Here, we will explore some of the common types of stock option plans used in the Indian stock market:

  1. Incentive stock options (ISOs): ISOs are primarily designed for employees and offer them favourable tax treatment. Employees who receive ISOs do not incur tax liability when the options are granted or exercised, provided they meet specific holding period and other eligibility requirements. These plans encourage long-term commitment to the company.
  2. Non-qualified stock options (NSOs): NSOs are more flexible than ISOs and are often used for a broader range of employees, including executives and consultants. Unlike ISOs, the income from NSOs is typically subject to ordinary income tax at the time of exercise. Employers also have more discretion in setting the terms and conditions of NSOs.
  3. Restricted stock units (RSUs): RSUs grant employees the right to receive company shares at a future date, subject to certain conditions. Unlike traditional stock options, RSUs do not require an upfront purchase and may vest over time or upon the achievement of performance goals. Once vested, employees receive the underlying shares.

It is important to note that the tax treatment and regulatory requirements for these stock option plans can vary. Companies often carefully design these plans to meet their specific objectives and comply with local laws and regulations. Employees, whether receiving ISOs, NSOs, or other forms of stock options, should fully understand the terms and tax implications of their grants to make informed financial decisions.

Features of Stock Options

Mentioned below are the characteristics of Stock options:

  1. Date of Expiry
    Options allow a trader to not only bet on a stock rising or falling but also to specify a specific date when the stock is expected to climb or decrease. The expiration date is what it's called. The expiration date is significant because it aids traders in determining the time value of the put and call, which is employed in various option pricing models.
  2. Strike Price
    Whether or not an option should be exercised is determined by the strike price. A trader would expect the stock to be above or below this Price by the expiration date. A trader might buy a call for a specific month and strike price if they believe IBM will rise in the future.
  3. Contract Size
    Contracts denote the number of underlying shares that a trader wants to purchase. One hundred shares of the underlying stock are equal to one contract.
  4. Premium
    The premium - is the price paid for an option. It is calculated by multiplying the call price by the number of contracts purchased, then multiplying by 100.

Parameters

  1. Tax implications: Understanding the tax consequences of stock options is crucial. When you exercise your options and eventually sell the stock, you may be subject to different tax treatments depending on the type of options you hold and how long you have held the shares. Consulting with a tax professional or financial adviser can help you navigate the complex tax aspects of stock options and make informed decisions.
  2. Risk and reward: Stock options offer the potential for substantial financial gains, especially if the company's stock price appreciates significantly. However, they also carry risks. If the stock price does not exceed the exercise price, the options may never become profitable. It is important to assess the risk-reward balance and consider your overall financial situation when managing stock options.
  3. Diversification: As an employee with stock options, it is crucial to maintain a diversified investment portfolio. Relying too heavily on your company's stock can expose you to undue risk. Diversification can help protect your financial stability.

Trading stock options

Here are some basic points to get you started:

  • A stock option is a contract between two parties that gives the buyer the right to buy or sell underlying stocks at a predetermined price and within a specified time period.
  • The seller of the stock option is called an option writer, where the seller is paid a premium from the contract purchased by the buyer.
  • Stock options come in two basic forms: Call options afford the holder the right, but not the obligation, to buy the asset at a stated price within a specific time period. Put options afford the holder the right, but not the obligation, to sell the asset at a stated price within a specific time period.
  • The option price is determined by the market forces of supply and demand.
  • Stock options are used for various purposes such as hedging, speculation, and income generation.

Example

Let us explore a scenario involving Mr. X, an experienced investor, who believes that shares of "TechGen innovations," a fictitious tech company, are poised for a significant upswing. Mr. X is considering two primary options strategies to capitalise on his market outlook.

Strategy 1: Writing put options

  • Choice: Mr. X decides to write put options on TechGen innovations.
  • Details: Mr. X is selling four put options for TechGen Innovations with a strike price of Rs. 1,500 and an expiration date in May. By doing this, he's giving others the right to sell him TechGen shares at the strike price.
  • Premium: Mr. X receives a premium for writing these put options. Let us assume he collects a premium of Rs. 5,000 per put option, totalling Rs. 20,000 for all four options.

Outcome: If the stock price of TechGen innovations remains above INR 1,500 by the option's expiration date, the options will expire worthless, and Mr. X will retain the entire premium. However, if the stock price falls below Rs. 1,500, the put option holders can sell their shares to Mr. X at the strike price, potentially resulting in a financial loss for him as he will be obligated to purchase TechGen shares at Rs. 1,500 each.

Strategy 2: Buying call options

  • Choice: Alternatively, Mr. X can buy call options on TechGen innovations.
  • Details: He purchases TechGen innovations July Rs. 2,000 call options, which grant him the right to buy TechGen shares at the strike price of Rs. 2,000 by the option's expiration date.

Outcome: If the stock price of TechGen innovations rises above Rs. 2,000 by the option's expiration date, Mr. X can exercise the call options, buying the shares at the lower strike price. He can then sell them at the market price for a profit. However, if the stock price does not reach Rs. 2,000, he will let the call options expire, incurring only the initial premium paid for them.

These examples illustrate how investors can use stock options to implement different strategies based on their market expectations. The key is to thoroughly understand the mechanics and risks of each strategy and aligns them with your financial goals.

Conclusion

It is crucial for employees who receive stock options to fully grasp how they operate before deciding when to exercise and sell them. Consulting a financial adviser can be beneficial for developing a financial strategy that includes stock options or other investments, as they can provide guidance on when and how to make the most of this compensation benefit.

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Frequently asked questions

Is it true that options are better than stocks?

If you want to minimise risk, options might be a good choice. Options can help you achieve stock-like returns with a smaller investment, making them a suitable way to manage risk. However, options can be a complex strategy and are best suited for experienced investors.

Is it true that options are riskier than stocks?

Investors may find options to be less risky than equities because they require a smaller financial commitment and may be less susceptible to the potentially catastrophic impact of gap openings.

What's the distinction between a stock and an option on a stock?

Stocks give you a partial ownership stake in a company, while options are simply contracts that give you the right to buy or sell a stock at a specific price by a specific date.

Are stock options and share options the same?

The key difference between shares and options is that when someone buys shares, they immediately become a shareholder in the company. Option holders have the right to purchase shares at a future date.

How does stock options work?

Stock options provide investors with the right, but not the obligation, to buy (call option) or sell (put option) a specific number of shares of a company's stock at a predetermined price (the strike price) within a set timeframe. These options are traded as contracts and are used for speculating on future stock price movements. Call options are used when investors expect stock prices to rise, while put options are used when they anticipate a decline. Options can be bought and sold on various financial exchanges, and the profit or loss depends on the stock's performance relative to the strike price.

What are the two main types of stock options?

The two primary types of stock options are call options and put options. Call options give investors the right to buy the underlying stock at the strike price, which is used when they anticipate the stock's price will rise. Put options provide the right to sell the underlying stock at the strike price, which is used when they expect the stock's price to fall. These options are bought and sold as contracts, and each contract typically represents 100 shares of the underlying stock.

How can I buy stock options?

You can purchase stock options directly from a financial exchange. To do this, you will need to open an account with a stockbroking firm like Bajaj Financial Securities, where the options are listed. Once your account is set up, you can place orders to buy specific options contracts. These orders will specify the type of option (call or put), the number of contracts, the strike price, and the expiration date. The options will then be bought and added to your account, and you can trade them as needed. It is important to understand the mechanics and risks of options trading before buying them.

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