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Financial Literacy

Understanding Stock Options Like A Pro

Are you interested in maximizing your potential investments? If so, you’ve probably wondered what stock options are and how you can start profiting. Understanding stock options can help you determine if this is the right investment opportunity for your portfolio.

The stock market presents traders with opportunities every day. And I’m going to provide you with some insight on how you can generate profits in both the long and short-term.

Understanding stock options through your tablet

Understanding Stock Options: The Basics

Stock options give you the right to buy or sell an underlying stock. In fact, it allows an investor to bet on the rise or fall of a stock. Often times, larger corporations will purchase stock options to hedge risk exposure.

There are two types of stock options, a call option and a put option. Options are essentially a tool to magnify movements in the stock market.

Call options are contracts that give their holder the right – but not the obligation – to buy shares at a certain price. If an investor trades a call option, they are betting that the underlying stock’s price will rise above the option’s strike price. Moreover, the contracts will give their owner the ability to buy at a discount. When that happens, those calls are referred to as “in the money.” If a call option’s strike price is above the price of its underlying security, it’s referred to as “out of the money.”

A put option is the opposite. They give their holder the right – but, again, not the obligation – to sell shares of a stock at a certain price. A put is a bet that the price of the underlying shares will go down below the option’s strike price and allow the holder to sell the options at a premium. It’s the same story whether a put is in the money or out of the money. If a put option’s strike price is above the market price, it’s in the money. If the strike price is below the market price, it’s out of the money.

Stock Options Example

To really gain an understanding of stock options, let’s go over an example…

An investor speculates the price of stock “A” will rise in three months. Stock A is currently priced at $10, so the investor buys a call option with a $50 strike price, which is the price the stock must surpass in order for the investor to profit. Let’s fast-forward to the expiration date, where stock A has now increased to $70. The call option would be worth $20 since stock A’s price is now $20 higher than the $50 strike price. If the underlying stock were to have fallen below the strike price by expiration, this investor would have profited from a put option.

Stock options can also be used as incentive to attract potential employees. Many companies are including this as part of their compensation package.

Employee Stock Options

The number of options an employee receives depends on the company, your skills, seniority, etc. Upon receiving the stock options, both the employer and employee will sign a contact outlining the terms of the stock options. The contract will specify what date your options begin to vest, meaning the date you are eligible to exercise or buy. Typically, there is a vesting period, meaning the options will vest gradually rather than become available to you all at once. That being said, an employee will have to stay with the company for at least one year before they are able to receive any of the options.

And it’s important to note that the options do in fact have an expiration date. Typically, they will expire ten years from the grant date OR 90 days after you leave the company. This information can always be found in your contract. Understanding stock options can be difficult if you don’t pay attention to these minor details.

When and How to Exercise Stock Options

There are many factors that will determine when you should exercise your stock options. It’s common for people to wait until the company has gone public. If you don’t wait, the shares might be worth less than what you paid – or even worthless.

Once the company has its initial public offering (IPO), you’ll want to exercise the options. Once the options have been exercised, your money is sunk in those shares. Therefore, it’s best to wait until the market price gives you a chance to sell.

As soon as the vesting period is over and you are able to exercise the options, you have a couple ways of exercising them…

  • Exercise options – Once you exercise the options, you own the stock. Now you can either sell or hold onto it in hopes the stock price will rise.
  • Exercise-and-sell – Purchase options and sell right away. The brokerage handling the sell will front the money so you don’t have to use your own money to exercise the options. The brokerage will use the money that was made from the sale to cover what it costs to buy the shares.
  • Exercise-and-sell-to-cover – Sell enough shares to cover the purchase of the shares and hold the rest.

Starting in Stock Options

There is so much more to learn about stock options. Now that you have some insight into the options market, continue growing your knowledge and start profiting by signing up for Trade of the Day. It’s a free e-letter that provides analysis, tips and more from two of the best trading experts, Bryan Bottarelli and Karim Rahemtulla.

Are you ready to begin trading options? Whether you are a novice investor or experienced trader, it’s always important to stay ahead of the latest trends and investment strategies. This is why having a better understanding of stock options can help you enhance your portfolio.


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