Stock option – what is it?
Options can be divided into two main types: put options (for selling) and call options (for buying), but this is not the only classification of this type of security. Experts also distinguish three types of deals depending on the underlying asset. One of these types is the stock option.
Standard Stock Option
A stock option is an option where the underlying asset is another security. Most often, these are shares of a single company or a basket of shares from several organizations.
The underlying asset is the main object of the deal. The buyer of the option receives the right to buy or sell that asset. The contract specifies the strike price of the underlying asset, which remains unchanged for the entire term of the deal.
Sometimes the terms “stock option” and “exchange-traded option” are confused. An exchange-traded option is a contract regulated by a stock exchange. In English, these terms are very different and used separately, but in Russian they are often confused due to the similarity of the words “фондовый” (stock) and “биржевой” (exchange-traded), so much so that this confusion is no longer considered a mistake.
Examples of Using Stock Options
In addition to stock options, there are also commodity and currency options. Classification by the type of underlying asset is necessary due to their different uses. For example, commodity contracts are mainly used by producers to insure their investments, while currency options are favored by Forex traders for profit.
Stock options are equally popular for both hedging and generating profit.
Using Stock Options for Investment Insurance
For such purposes, it's more appropriate to purchase a put contract. It gives the holder the right to sell the underlying asset (in this case, shares) at a fixed price.
For example, let’s take the shares of a large company. Suppose the price is $500 per share, and the average package bought is at least 10 shares.
The investor buys the minimum package after analyzing the market and concluding that the stock price will rise.
Later, financial analysts begin predicting a market crash. The investor decides to hedge and buys a put option to sell the shares at the current market price. The contract term is 2 months, and the premium is 8% of the investment. For a $5,000 package, the investor pays a $400 premium.
The analysts’ prediction turns out to be correct, and the company’s stock falls by 10%, with more drops expected. It makes no sense for the investor to hold the shares, as they could lose value. So, the investor exercises the option and sells the shares at the purchase price, losing only the 8% premium instead of 10% or more.
Using Stock Options for Profit
The same situation can also bring profit — that's exactly what experienced traders do.
For example, one trader, hearing the analysts’ prediction, buys a put option. This gives them the right to sell the shares at the current price of $500 per share. The premium is also 8% of the investment, and the quantity of the asset is predetermined.
The trader decides to take a risk and buys an option to sell a package of 100 shares at $500 each. The premium totals $4,000.
The trader waits until the price drops. By the contract’s expiration date, the share price has fallen to $375, a 25% drop.
The trader buys the shares on the open market at $375 each and sells them via the option at $500. The profit is $12,500.
If a price increase was expected instead, the trader would buy a call option. When the price rises, the trader buys the shares at the lower strike price and sells them at the higher market price.
Issuer Option
A standard stock option has a special subtype — the issuer option.
The issuer is the organization that issues options for its own development, with its own shares as the underlying asset.
These are barrier options, meaning they can only be exercised under certain conditions. If the condition isn’t met by the expiration date, the contract becomes void. Issuer options are similar to European-style options because they cannot be exercised early.
These are available to all exchange participants but have recently become more popular within the company itself. They are used to motivate employees, given as bonuses. The condition for exercising the option is an increase in the company's stock price.
If an employee wants to make any profit from this option, they have to work harder and contribute to the company’s success. Although the efforts of one employee may not affect the entire company, they can improve the performance and efficiency of their department — which is exactly the purpose of this type of option.