Stock Options

Stock Options are derivative instruments that give the holder the right to buy or sell any stock based on its predetermined prices regardless of the prevailing market prices. In stock options trading, the two types are call options and put options. These types vary based on whether the traders want to purchase or sell a particular stock.

The two major styles of these options are the American style which allows the holder to exercise an action within the expiration date and the European style where the holder can exercise their stocks only on the expiration date. These types of deals are also safer in some regard from regular stocks as risks are better hedged.

1. Stock options are granted to the investor to buy or sell a stock at a decided price and time under the terms of a stock option. 
2. Options come in two flavors: puts, which wager that a stock will decline, and calls, which wager that a stock will climb.
3. There are four indicators of stock options, Delta, Gamma, Theta, and Rho.
4. Stock options provide leverage, flexibility, and the ease of short selling. However, it also has certain shortcomings, such as no stockholder privileges and future risk. 

Stock options are a preferred financial instruments by asset management companies, portfolio managers, foreign institutional investors, stock options are preferred financial instruments, etc. It gives the benefits of betting with huge exposure based on the specific insight of the stock price movement in a particular direction.

There are a handful of components that comprise to become a deal for both parties involved. The components are:

• #1 – Strike price – Strike Price is the price of purchased or written options.
• #2 – Expiry date – All the stock options will have a predetermined expiry date on which the instrument will be squared off.
• #3 – Premium – The price of the options one can write or buy.
• #4 – Lot size –  Stock options based on the prevailing market price of a share consists of a fixed number of shares termed Lot Size.

Companies also offer employee stock options where they are provided with a derivatives option on the stock. The employees can purchase a stock at a predetermined price for a finite time. These schemes provide employees to gain equity compensation in addition to or instead of regular compensation.

Let us understand the types used in the stock options trading segment of the market through the discussion below.

• 1 – American Style – American option can be exercised at any time, even before the expiry.
• 2 - European Style - The European option that can be exercised only at the time of expiry can be exercised only at expiry.

The payoff in options will always be considered at maturity. Initially, while writing or b

At maturity, the payoff in options is always considered. Initially, premium inflow or outflow will occur while writing or buying options. On maturity, cash inflow (in case of profit) or cash outflow (in case of loss) net off premium will occur.

Hence, the following is the formula for Payoffs in stock options trading is:

Payoffs Formula = (Maturity Price – Strike price) * Lot Size – Premium paid on the inception.

Let us understand the concept of employee stock options and other such types with the help of a few examples. These examples would help us grasp the intricate details of the concept.

Example #1

Call option of Amazon.com :

• Current market price – $30
• The strike price of the option – $40
• Premium – $5
• The market price on expiry- $20 and $60
• Lot size – 100 shares

Solution

If the Market price is $20, it is below the strike price. Hence, the option will lapse.

Hence total loss = $5

If the Market price is $60, it is above the strike price. Hence, the option can be exercised.

Calculation of Payoff Maturity 

Payoff on maturity = ($60 – $40) * 100 – $5

= ($20) * 100 – $5 = $2,000 – $5 = $1,995

Example #2

Mr. A bought the put option of Facebook Inc. with the expiry date of 30th April. On 1st April, the market price of Facebook Inc was $136. The put option premium for a strike price of $150, with the expiry of 30th April, is $1,000. The lot size is 1000 shares. Calculate the payoff for the option if the market price on 30th April is:

• $110 
• $180

Solution

Here, Mr. A is the buyer of the put option. Hence, he can buy the share if the price goes below the strike price. For example, on 30th April, if the market price is $110, it is below the strike price of $150. Hence, please put it in the money, and options will be exercised.

On 30th April, if the market price is $180, it is above the strike price; hence, options will lapse.

Therefore, total loss = $1,000

Calculation of Payoff 

Therefore, payoff = ($150 – $110) * 1000 – $1,000

= $40,000 – $1,000

= $39,000

Let us understand the indicators of the stock options trading that help the parties involved to predict or take a calculated and educated guess about the movement of the price in the open market through the points below.

• Delta:  The degree to which option price will change concerning change in the market price.

• Gamma: The degree at which the option's delta (as discussed in 1) would change concerning the change in market price. In simple terms, it is termed the delta of the delta.
• Theta: The degree of change in option price concerning a change in the expiry of the option instrument.
• Rho: The degree of change in option price concerning a change in risk-free interest rate.
• Vega: The degree of change in option price concerning the change in volatility.

Given that employee stock options and options, in general, are a better way of hedging risk, it is important to understand other such benefits as well before investing through such deals. Let us understand the benefits in detail through the explanation below.

• Leverage – Buying stock requires upfront payment on the inception, which requires a huge cash outflow. However, with less initial investment, an investor can take huge exposure over the underlying asset in an option.
• Ease of Shorting – Short selling shares brings a huge amount of risk and legal repercussions. However, with options, one can easily take a short position by paying a premium based on the speculation or having specific insight.
• Flexibility – Options can be structured based on the needs of investors. There are numerous strategies like a straddle, stranded, and bull call spread which refers to a trading strategy where the trader speculates a limited price appraisal of the stock. Here, the trader bets on the same stock via two call options for the upper and lower strike price range, bull call spread, etc., based on which investors can design and earn huge profits.

Despite the significant benefits mentioned above, there are factors from the other end of the spectrum that need to be discussed. Let us discuss the drawbacks of regular or employee stock options through the points below.

• Risk – Option buyers will have losses limited to the premium amount paid. However, the writer of the options will face a huge risk. It can even be unlimited. Hence, stock options come with a huge risk compared to a direct purchase.
• No Stock Holder Privileges – Shares, once purchased, can be sold even after a hundred years at investors’ wish. However, there is a fixed, predetermined expiry date on which an instrument is needed to be squared off in options. Due to this, even if the investor incurs negative profits, they will have to forcefully square off the instrument even at a loss.
• Constant Observation of Market Prices for Premium Payoffs – Generally, the investor pays the purchase price in share investment. After that, no payment is needed. However, the option seller will have to monitor the market prices constantly based on which the market to market price of an instrument will be settled at the end of the day.

Both stock options and Restricted Stock Units (RSU) have been widely discussed, analyzed, and used in deals in the stock market. Let us understand the differences in their fundamentals and other details through the comparison below.

Stock Options

• Stock options are a type of security given to an investor, trader, or sometimes even employees to buy or sell shares of a company at a predetermined price before an expiry date.
• The holder of such stocks will not be entitled to receive dividends from such stocks as they do not have the authority of ownership.
• Income from such deals is taxable when their rights are exercised and not when they are just holding them.
• There is an expiration date before which the right has to be exercised. Post the expiration date, the rights over these stocks become null and void.

RSUs

• Restricted Stock Units or RSUs are a form of stock or equity-based compensation used to motivate or reward employees who have achieved a set of targets.
• They are fully entitled to receive dividends during the vesting period. After the vesting period, they are paid in cash.
• The income from such stocks is taxable after vesting.
• There is no expiration date on RSUs.

This has been a guide to what are Stock Options. Here we explain its types, examples, benefits, and drawbacks, and compared it with restricted stock units. You can learn more about accounting from the following articles –

• ESOP Meaning
• Non-Qualified Stock Options
• Stock Options vs. RSU
• Stock vs. Option