Stock Options Explained For Beginners
Investors often ask what stock options are, how they work, and why they should use them. Stock option basics can be difficult to understand for beginners because there is a lot of jargon involved with the process.
In this article, I hope to answer all your questions about stock options so you know exactly what you’re getting into before investing in them.
What is a stock option?
A stock option is a contract that gives an investor the right to buy or sell shares of a particular company’s stock at a certain price, for some period of time. The thing you need to know about options is that they are traded on exchanges like stocks and can be bought and sold just like them. They also have expiration dates so it’s important to get familiar with the different types of expiration dates.
How do stock options work?
When you invest in a stock, it’s possible for the price to increase or decrease and there are no guarantees about whether your investment will be profitable. With options, however, investors have more control because they can lock-in an agreed upon purchase price before expiration which is what we call “exercising” the option.
With this type of guarantee, investors know what price they’re investing in upfront and can protect themselves from unnecessary risk.
This is why we call them “safe” investments because you have more control over your investment and the downside isn’t as high if things don’t work out as planned.
Depending on how long the investor wants to hold onto their stock options, they can choose the appropriate expiration date.
What are the types of options?
There are three types of options that have different levels of risk and reward: a call option, put option, or an American-style option.
Call options allow investors to buy shares at a set price before expiration; if the stock goes up in value during this time period it’s possible for them to make some money.
Put options allow investors to sell shares at a set price before expiration; if the stock goes down in value during this time period it’s possible for them to make some money.
American-style options are more risky because they can be exercised only on the date of their expiration, but there is no limit as to how long they can be held onto for.
If you’re looking to trade stock options and want a safer investment, go with the call option which allows investors to buy shares at an agreed upon price before expiration.
Why do investors use stock options?
Stock options are good for investors because they offer predictability and control over their investments. They also allow you to tailor the level of risk, reward, and time frame that will work best with your investment needs. There’s no need to invest a large amount on stock trading right away or worry about the price of the stock because you can lock in your purchase for a finite period before it’s too long past.
Investors often use these options to hedge against other investments they have on the market since there is more predictability with this type of contract. You also don’t need as much capital upfront, and like I said before, if things don’t work out as expected you can always sell them before the expiration date.
What is the terminology for stock options
- Expiration date: the last day that an option can be exercised. This means to buy or sell a contract (known as exercising) that has already been bought and sold in advance, for example American-style options which expire long before you have access to them otherwise.
- Strike price: the agreed upon purchase price before expiration.
- Exercise date: this is when you buy or sell a contract that has been previously bought and sold in advance. This is often done with American-style options because they can expire long before you have access to them otherwise. An investor’s ability to exercise their contracts depends on the type of options they have purchased.
Is buying stock options risky?
No. Stock options are not risky because they offer predictability and control over your investment, which is why we call them “safe” investments – you have more control over the downside if things don’t work out as planned.
Are options better than stocks?
It’s difficult to say which one is better because they have different benefits and drawbacks. For example, for an investor who wants a safe investment there are call options that offer you more control than stocks. On the other hand, if investors want a high-risk and high reward then they should go with put options or American-style options.
With stocks, the upside is much higher, but if you want a predictable and more secure investment then stock options are the way to go.
How do you trade stock options?
Trading stock options is not a complicated process and it can be done in three easy steps:
- Choose which type of option you want to invest in (call, put, or American).
- Set your strike price. This means the agreed upon purchase price before expiration.
- Exercise them on the date that they expire, or wait for them to expire if you’re not quite ready.
How do you calculate the worth of your stock options?
Here’s a way to calculate the worth of your stock options:
- If you have a call option, the formula is (strike price+all costs) – current stock value.
- For put options, it’s strike price+(current market value of stocks x time to expiration) + all other costs.
- The third way that you can calculate your worth is by multiplying the number of shares times the price of the stock minus all other costs.
Decide which one will work best for you and enter it into a spreadsheet with your values in order to see what they’re worth. The downside is that this method doesn’t account for any time value unless you calculate the time until expiration first, but if you have an exact date of when you plan on exercising the option then this is a good way to go.
The downside of using put options in your calculations, as opposed to call or American-style options, is that they require more upfront capital and the upside potential for them isn’t as high so if there’s any chance that it won’t work out then sticking with call or American-style options would be the better option.
What are corporate and employee stock options?
Corporate stock options are the ones that companies offer to their employees, and they work by providing them with a certain number of shares in order for them to have the opportunity to purchase more if and when it is needed.
Employee stock option programs (ESOPs) are usually structured so that workers have an income while waiting until the options are purchased.
This is advantageous because it offers some stability in their income while also helping to control the company’s stock prices, which will have a positive effect on recruitment and retention.
ESOPs can be beneficial for companies too because they offer them with an alternative way of financing growth if other methods aren’t available or possible.
The downside is that the growth in stock price for ESOPs can be slowed down because of the time it takes to buy them.
Employee stock options are a great way for companies and employees alike to make some money without having any financial risk involved, where they only get paid out when they have exercised their contract rights. This can be a great way to incentivize employees, and it also works as an incentive for them not to leave the company because they won’t get paid unless they work there.
Do you need help understanding stock options?
If you need help with stock options, there are several free resources online that can give you advice on how to trade stock options and what strategies work best for different types of investors:
- Investopedia’s Guide to Options Trading is a good place to start because it provides a lot of information on terminology and the different types of stock options.
- The Options Institute also provides free resources for investors, like tutorials about how to trade stock options.
- You can even find YouTube videos from financial experts that will give you advice about which strategies work best in certain situations.
Stock options and Fast Fortune Club
You should now have a better understanding of how the stock options process works. It's important to do your research before investing in anything.
Fast Fortune Club offers stock options for a variety of different companies, both public and private. It has access to the most popular stocks on major markets like NASDAQ, NYSE, AMEX and London Stock Exchange.
Fast Fortune Club offers two types of purchase methods:
- You can buy American style stock options with only one price at which you can buy or sell a stock.
- You can also purchase European style options, which are priced differently depending on whether the market price is higher or lower than what’s been agreed upon in the contract.
I Buy I Review recently reviewed the Fast Fortune Club’s subscription stock trading service. You can read the review of Fast Fortune Club here.
I buy and review courses so you don’t have to. Sometimes, I even find courses that are legitimate and worthwhile; and that’s how I accidentally came across one that led me to building a 6-figure business in a little under 5 years. Now, I still review courses because it’s my favorite hobby. 🙂 Learn more about me here.