Stock Options 101
A stock option is a security whose value is based on the value of a particular stock, which is called the underlying security. Stock options allow you to leverage stock trades. This means you invest less money per share and so increase the potential return on your investment. However, you also increase your risk. Although stock options are a valuable tool for stock investors, the higher risk means you should have some experience trading stocks before you tackle options trading.
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Definition
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A stock option is a contract that confers the right to purchase or sell stock at a guaranteed price, which is called the strike price. Traded option contracts such as those listed on the Chicago Board of Options Exchange follow a standardized contract format for 100 shares. You can exercise the option anytime until its expiration date (called the expiry). Sellers of options contracts (called writers) issue them for periods ranging from a few months to several years. If you choose to exercise a stock option, the writer must complete the transaction.
Types
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Stock options come in two basic types: calls and puts. A call option contract allows you to buy shares of the underlying security at the stated strike price. If the market price of the stock goes up, you can exercise the options to buy the shares at the strike price and then sell the shares at the market price, making a profit. Put options give you the right to sell at a guaranteed price. If the market price of the stock falls, you can buy the shares on the open market, and then sell them to the option writer for the higher strike price. However, if the market price of the stock doesn't go your way before the option's expiry so that you can exercise it for a profit, the option contract is of no value and will expire. In that case, you lose the money you put up to buy the stock options.
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Trading
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Suppose you buy a call contract for 100 shares of XYZ Co. with a strike price of $20 per share that will expire in three months. The option writer charges a premium of $1 per share. The premium is the fee the option writer gets to cover her costs and make a profit. Let's say the stock goes up in price to $25 per share before the expiry date. You can exercise the option by paying the strike price for the shares, and then sell them on the market. You make $25 per share minus the strike price of $20 per share and the $1 per share premium, or $4 per share. Because you only risked $1 per share (the premium you paid) you make a 400 percent profit. However, if the stock's market price doesn't go up before the option expires, you lose the money you risked.
Employee Stock Options
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Many companies award employee stock options to valued employees. If you receive a grant of stock options, you don't face any risk because you didn't pay anything for these options. However, you have to pay attention to the terms of the option contract. Employee stock options are always call options, but they come in two forms: nonstatutory and incentive. With nonstatutory options, you can exercise the option contract anytime after any required waiting period until the option's expiration date. With incentive stock options, if you wait one year before exercise and then hold the shares for one more year before selling them, your profits are considered long-term capital gains and taxed at lower rates.
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