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There are many ways investors can gain exposure to the stock market, including stock options. Stock options, which are traded publicly on options exchanges, are a kind of derivative investment — that is, their value is derived from something else. In this case, it’s stocks. Options can be a confusing area of the market for some investors but may be worth having on your radar. Here’s how investing in stock options can be used to help you build wealth.
What are stock options?
An option is a contract between prospective buyers and sellers of stocks. The option writer puts a contract up for sale on an options market, offering to sell or buy a certain stock at a certain price by a certain date. The buyer of the option pays money, known as the premium, for the right (but not the obligation) to execute the other side of the trade. The contract itself is tradeable — the holder may go on to sell the option to another buyer, and it may even change hands many times before the option is either exercised or expires.
Understanding stock options
The value of the option lies in the likelihood that executing the contract generates a profit for its owner. For example, a call option to buy 100 shares of XYZ Corp. at a "strike" or exercise price of $50 is said to be “in the money” if the stock is currently trading at $55. The option will be worth at least $500 (100 X $5) because that’s how much you would earn if you exercised it right now.
Drivers of stock option prices
Stock options may still be worth something even if they are "out of the money" — when the strike price of the option is above or below the current market level. That’s because there still may be time for the stock to rise in value (with a call option) or fall in value (with a put option). Hence the value of the option is driven by:
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The market price of the stock
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The term to expiry
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Potential catalysts that might affect the stock’s price before the option expires
How to exercise stock options
When the holder of an option chooses to exercise their option, they contact their brokerage to indicate their intentions. Though the settlement process can be complex and may involve multiple brokerages, the shares are effectively transferred from the writer’s account to the option holder’s account, in the case of call options — or in the opposite direction, in the case of put options — in return for an amount of cash representing the number of shares multiplied by the strike price. If the seller of the shares does not currently own the stock, they may be left in a short position, meaning they would have to buy the stock at the market price or face a reconciliation with their brokerage.
Examples of stock options
Stock options may be used for different reasons in different situations:
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A fund manager may buy options to help manage their portfolio risk; for example, the right to sell a risky stock in case it plunges in value.
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A manager may also write options to help generate income for unitholders.
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An investor may buy options as a cheaper way to benefit from a rise (or fall) in a stock’s price than buying (or shorting) the stock itself.
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A company may issue call options for its own stock to senior employees as extra incentive to work toward adding value to the company.
How do employee stock options work?
Stock option granting
Many companies offer stock options to employees to boost compensation. Rather than granting shares directly, the employee receives a call option that gives them the right to buy the company’s stock at a specific price for a particular period of time. Employees make money when the stock price climbs above the exercise price. For instance, if the option’s exercise price is set at $10, but the stock price rises to $15, they can exercise that option for $10 and immediately sell those shares to pocket the $5 difference or hang on to the stock in the hopes it rises more.
Vesting
In addition to a maximum holding period prior to expiry, employee stock options may have minimum holding periods according to a vesting schedule. Typically, a new hire may have to wait a year or more before they can exercise any of their options, and at least four for all of their options to vest. This can provide an incentive for employees to stay with the company.
When to exercise stock options
It can make sense to exercise an option at any time within the vesting window when the options are “in the money” and you have the cash to make the share purchase.
Types of stock options
Call options
Call options confer on their holders the right, but not the obligation, to buy a stock (usually in batches of 100) at the strike price before the expiry date. Buyers of call options are betting that the stock value will rise.
Put options
Put options give their holders the right to sell a stock at the strike price before the expiry date. Buyers of put options expect the stock will fall or want to be prepared in case it does.
Single stock options
Single stock options have just one underlying stock. When you exercise a single stock option, you acquire or sell shares of that stock.
ETF options
With ETF options, the underlying security is an Exchange-Traded Fund (ETF). When you exercise an ETF option, you acquire or sell units of the fund.
Benefits of stock options
- Cost efficient: Options typically trade for a fraction of the cost of the underlying shares.
- High potential returns: By magnifying the valuation gap between the strike price and market price, options can leverage returns on the upside.
- Provides strategic alternatives: Options trading can be profitable in rising or falling markets alike, providing returns that are uncorrelated to equity holdings.
Risks associated with stock options
- High risk: Options carry significantly higher risk compared to traditional stock market transactions. Most options expire worthless.
- Complicated tax implications: Holders must pay tax when they exercise options or sell them for a profit. In Canada, however, options can be held in tax-advantaged registered accounts.
- Valuation challenges: As typically short-term investments with an expiry date, options can be hard to calculate as part of your asset base or net worth.
FAQs related to stock options
How can I use options as a stock replacement?
Options with long terms to expiry (more than a year) are known as LEAPs — long-term equity anticipation securities. When LEAPs are "in the money," they track the movement of the underlying stock’s price (in reverse in the case of puts). But because options are much cheaper than the stocks they represent, they create the opportunity for investors to potentially acquire a more substantial position in a company than they would if they were to buy the actual stock.
Why do companies provide stock options to employees?
Employee stock options (ESO) are a talent retention tool. They reward performance and long tenure when the company is prospering, without having to pay higher salaries. Over time, they can also boost alignment between management and shareholders.
Are employee stock options worth it?
ESO plans plans can place an administrative burden on the company and can potentially dilute existing shareholders’ equity, however, they may be seen as a relatively low-risk way of attracting top talent. For employees of growing companies, they can be highly remunerative.
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