Stock Options: A Practical Guide

What is a stock option?

A stock option is a contract that gives the holder the right — but not the obligation — to buy or sell a specific number of shares of an underlying stock at a predetermined price (the strike price) before or on a specified expiration date. Options are equity derivatives: their value is derived from the price of the underlying security.

Two basic types:
* Call option — the right to buy the underlying stock (bullish).
* Put option — the right to sell the underlying stock (bearish).

Options are commonly used for hedging, income generation, or speculative leverage.

How stock options work

• An option’s value consists of intrinsic value (when the option is in the money) and extrinsic/time value (the premium reflecting the chance it moves into the money before expiration).
• “In the money” (ITM): strike price is favorable relative to market price (e.g., call strike below market price).
• “Out of the money” (OTM): no intrinsic value but may retain time value.
• Exercising an option converts the contract into the underlying shares (for calls, you buy shares at the strike; for puts, you sell shares at the strike).

Options allow exposure to price moves with less capital than owning the stock outright because one options contract typically controls 100 shares.

Key parameters

• Style:
• American — can be exercised any time before expiration.
• European — can be exercised only at expiration.
• Expiration date — the final day the option can be exercised. Longer-dated options carry more time value.
• Strike price — the price at which the underlying can be bought or sold if exercised.
• Contract size — standard U.S. options represent 100 shares per contract.
• Premium — the price paid per contract (quoted per share, multiplied by 100).
• Volatility — higher volatility generally increases option premiums because of greater chance of large price moves.

Common strategies

• Long calls/puts — buy calls to bet on a rise, buy puts to bet on a fall.
• Writing (selling) options — collect premium but assume potential obligation (e.g., selling a put obligates you to buy the stock at the strike if assigned).
• Spreads — combine long and short options with different strikes/expirations to limit risk and tailor payoff (e.g., vertical spreads, calendar spreads).
• Hedging — use options to protect stock positions (e.g., protective puts) or to generate income (covered calls).

Simple examples

• Call example: Buy 10 January $170 calls on a stock at $16.10 per contract → cost = $16.10 × 100 × 10 = $16,100. Breakeven = strike + premium = $186.10. If the stock stays below $170, the calls expire worthless and the premium is lost.
• Put example: Buy 10 January $120 puts at $11.70 → cost = $11,700. Breakeven = strike − premium = $108.30. If the stock stays above $120, the puts expire worthless.

Employee stock options (ESOs)

• ESOs are grants from an employer that give employees the right to buy company shares at a set exercise price after meeting vesting conditions. They function like call options but are not publicly traded.
• Typical features: vesting schedule (often with a “cliff”), expiration date, and possible restrictions on transfer or sale.
• Exercising ESOs issues new shares, which can dilute existing shareholders.

Common exercise methods if cash is limited:
* Exercise-and-sell — exercise options and immediately sell the shares to cover the cost.
* Exercise-and-sell-to-cover — sell just enough shares to cover exercise costs and taxes, keeping the remainder.

Valuing stock options

• Public company ESOs: intrinsic value = (market price − strike) × number of shares if in the money. Option value for traded options also includes time value and reflected in the market premium.
• Private company ESOs: valuation is more uncertain and often tied to recent company valuations or funding rounds; value can be speculative.
• Dilution matters: the total number of outstanding shares and options reduces the per-share value if many options are exercised.

Exercising options

• When you exercise a call, you pay the strike price to receive the underlying shares. For puts, exercising delivers shares at the strike.
• Considerations before exercising:
• Required cash to pay the strike price.
• Alternative exercise methods (cashless exercise, broker-assisted sell).
• Tax consequences and holding-period goals for capital gains treatment.

Tax implications (high-level)

Tax treatment depends on option type and timing; rules vary by jurisdiction. The following summarizes common U.S.-centric distinctions:

Statutory options (e.g., Incentive Stock Options, ISOs):
* No regular income at grant in most cases.
* Potentially favorable tax treatment if holding-period requirements are met (qualifying disposition). Exercise may trigger alternative minimum tax (AMT) reporting based on the bargain element (market price − strike).
* When shares are sold, capital gains tax applies; holding period determines long-term vs short-term rates.

Non-statutory / Non-qualified stock options (NSOs):
* Typically generate ordinary income on exercise equal to the bargain element if fair market value is readily determinable; employer reports it as wages.
* Subsequent gain or loss on sale is treated as capital gain or loss (short- or long-term depending on holding period after exercise).

Always consult a tax advisor for specific circumstances, timing, and local rules.

Risks and benefits

Benefits:
* Leverage — control exposure with less capital.
* Flexibility — strategies for income, hedging, or speculation.
* Employee incentives — align employee interests with company performance.

Risks:
* Total loss of premium for buyers if options expire worthless.
* Sellers face potentially large obligations (e.g., being assigned stock at an unfavorable price).
* Complexity — pricing depends on volatility, time decay, and other factors.
* Tax and dilution implications for ESOs.

Bottom line

Stock options are versatile instruments that let traders and employees gain exposure to equity price movements with defined terms (strike, expiration, contract size). Understanding the differences between calls and puts, the role of time and volatility, the mechanics of exercising, and the tax consequences is essential before trading or exercising options. For employee grants, pay particular attention to vesting schedules, exercise methods, and how exercising affects taxes and potential dilution.