How Do Stock Options Work?

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  • When an investor buys a stock option, he has the right to purchase or sell a specified quantity of stock shares at an agreed-upon price (also known as "strike price") before a specified date. The investor can choose to buy, to sell or just simply do nothing at all regarding the stock. This allows him to adjust his investment strategy according to the outlooks of the market. An investor can use stock options to gain profits against current stock holdings and protect stock holdings against stock depreciation.

    Most stock option agreements are for 100 shares of the underlying security. The price (premium) of a stock option is a small percentage of the stock value. Stock option premiums are quoted on a per-share basis.

  • Just like stocks, options are listed securities and traded regularly on the market. If the stock price increases, the stock option premium also increases, often at a much higher rate. This also means that stock option premium tends to decline faster than the stock price. Furthermore, if the profitable conditions for selling or buying the underlying security do not occur before the expiration data, the stock option will become worthless. However, the most an option buyer can lose is the premium.
    The number of options available on the market depends on the number of sellers and buyers who are interested in the rights of selling and purchasing a certain stock.
    Option holders do not have the rights to vote and to receive stock dividends.

  • Stock options are often offered to employees as a form of compensation. The employees have the right to buy a specified amount of common stocks of the company at an agreed price. In most cases, the strike price is the the value of the stock when the agreement is made. The employee can chose to excise the option in future when the stock price is higher than the strike price and gain profits by selling the stocks. This provides an incentive for the employee to work hard to boost the performance of the company stock to gain future financial rewards. The employee also might have to stay with the company for sometime before the stock option can be vested.
    Start-up companies often use stock options as financial incentives for their employees due to limited funding.

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