What are Stock Options?

2021-04-30 17:46:11
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A stock option is a financial contract that gives the buyer or the holder the rights but not the responsibility to buy or sell underlying assets at a special strike prize on or before the specified date of purchase, depending on the form of option (Cantrell 2008). The strike price can be put as the reference to the market price of the underlying commodity or security on the day an option is taken out. The strike prize can also be fixed at a discount or a premium. The seller of the commodity has got an obligation to fulfill the transaction that is supposed to sell or to buy if the owner exercises the right to an option.

There are two different types of option that can be used by the holder or the buyer. An option that obliges the owner the right to buy a commodity at a particular price is considered as the call (Simon 2001). The option that usually conveys the owner the right to sell a product at a given price is referred to as a put (Singh 2009). To exercise a call option; the strike price of the assets should be below the market price of the underlying commodity in question. For the holder to exercise a put option, the strike price of the assets should be above the market value.

If a seller does not grant an option to the buyer as another transaction such as a share or an employee incentive, then the buyer will pay a premium to the seller for the option. The cost to the purchaser of the assets acquired entails the strike prize plus the premium if at all the buyer will get any. In a situation where the option date expires before the option have been exercised, then the option is regarded as expired, and the buyer would pay the premium to the seller. The premium is usually an income to the vendor and a capital loss of the consumer. Variation of the market price of the option may occur due to significant option holders selling an option when the expiring date is very close, and he lacks the financial resources to exercise the option. Another way that the market price option can vary is when a buyer tries to amass extensive options holding. In that the holder is given the rights to buy the underlying assets, he is not given the right to voting or receiving any income from the underlying assets like the dividends.

Stock options from an employer give the worker the reasons to buy a specific number of shares from the employers company stock at a time and price that the employer will specify. Options are given for both the private and public held companies. The reason the stock options are given out is for the company to keep and maintain good workers, for the satisfaction of the employee so that they can feel like they are the owners or partners of the business. Companies offers stock option so that they could hire skilled personnel or workers by giving compensations that are above the salary.

How does stock option work?

Stock options work through the implementations of the stock option strategies. The stock option plan includes trading put and call option. A stock option contract can be used to show how the trade to happen. A stock option contract always represents one hundred shares of the underlying stock in the market CITATION Dar09 \l 1033 (Darwin, 2009). If the put and call option are given the buyer/ seller status, it means that four transactions would be covered. The operations would include put buyer, put seller, call customer and call dealer. If someone becomes an option buyer, he will pay the listed premium for the option whereas the seller of an option contract will obtain income that would be equivalent to the premium.

The trade stock options are frequently applied for logical reasons. For instance, if there is a situation that have arisen as a challenge to a particular company lets say the invasion of pests then the supply of pesticides will benefit from the situation. If the shares for the commodity X, which is pesticides, are at $ 5.28 today and the buyer expects them to rise with $10 or more during an epidemic, then maybe the buyer purchases the shares in February (expiry) 10 (strike) call option. If the premium cost is $60 per share, then the sum will be 60100 =6000. 100 represent the stock contract option. It, therefore, means that buying of a single option contract will cost $60, and if there are any commissions plus the strike price that is $10 per share, it means that by February expiry (every Friday of the month, the shares will need to increase by$ 10.60.

Utilizing these leverage instruments lead to quick gains but in most cases, the options expire worthless as there is a seller on the other hand who is deriving income from a speculative buyer who is verifying so that the stock should not reach the strike price that they sold.

Where Are Stock Options Offered?

Most firms offer stock options to all their employees. There are several potential economic justifiers for the practice. The first is to provide incentives to employees. This involves getting the employees more engaged as with some stock options; they can feel like part of the firm. The second reason stock options are usually offered to employees is to promote employees retention rates and induce the employees to sort.

Stock options are among the top strategies that are used by firms to attract and retain employees. This is understood in the concept that employees will have an incentive that will ensure they behave in ways that will boost the price of the companys stock (Understanding Employee Stock Options, 2013). If the value of the companys stock on the market rises above the nominal call price, the employees can then exercise the options, pay the due exercise charges and can be issued with ordinary shares in the company. This way the employee experiences a direct financial gain from the surplus of his trading the difference between the market and exercise places.

Companies also issue stock options to their employees to ensure that the cash flow is generated and preserved in thriving conditions. The cash flow comes around when new shares are received from the company, and the company receives the exercise price and receives a tax deduction that is equivalent to the intrinsic value of the stock options when exercised.

In most companies, employee stock options are issued to the management and top level. However, they can also be issued to non-executive level staff, basing on parameters that judge employee viability for the mission.

Also, business startups can find stock options a very useful means of remuneration. Before breaking even, cash may be a challenge for the young business, and this is where stock options would help workers to dedicate their time to the job. In this sense, stock options can also be issued to non-employees such as consultants, legal counsel, suppliers and promoters for various services rendered (Understanding Employee Stock Options, 2013). Employee stock options are equivalent to the exchange traded call options that a company may issue regarding its own stock options.

When Should an Investor Consider Buying Stock?

Regardless of the many benefits they offer, Options involve risks and are therefore not for anyone at any time. The investor has to formulate well-designed investment objectives to utilize the options optimally. The investor should put the place in place strategies that he hopes will allow the stock will hold steady in a fluctuating economy. Of course the strategies that may be implemented in place to determine the utilization of the stock options also heavily depend on the type of investor the stock option owner (writer). This distinguishes the investors between the conservative-oriented investor and the growth-oriented investors CITATION Und94 \l 1033 (Understanding Stock Options, 1994). Some strategies will help one access and offer a successful template for success in the world of stock options trading.

The stock options offered are valuable because they are an option. The stock option loses it value the moment the owner exercises it. This is because the holder of a stock option loses the prior flexibility over whether to buy or not once the stock option is exercised and the stock ceases to have its option value. Among the most critical variables to consider before using a stock option is the amount of money that the investor is willing to risk. Once the investor is satisfied that there is money sufficient to exercise the stock options while at the same time paying the due taxes, for example, the capital gains tax, the alternative minimum tax, and the ordinary income tax

During any particular period over the course of employment, the company may offer employees. Stock options that can be exercised at a particular price set by the enterprise (usually the companys stock price) on the grant day. Considering the vesting schedules and the time that the options may take to mature, the employees may choose to exercise the stock options at some point in time thereby legally obligating the company to sell the stock to the employee at whatever price that had been set on the grant day CITATION Und94 \l 1033 (Understanding Stock Options, 1994). At this particular point, the employee may elect to either sell the stock or hold on to it while speculating for a further appreciation of the price or the employee may choose to hedge the stock position through listed calls and puts. The worker may also elect to hedge the stock options before exercise with exchange traded calls and puts and avoid forfeiture of a significant part of the options value back to the company thereby reducing risks and delaying taxes.

Stocks versus options

Stock- (ownership of part of a firm) and options (the right to sell or buy stock of a company at a predetermined price) are related in many ways though each has both its advantages over the other.

Benefits of Stocks over options

Stocks are easier to get right; that is one only need to know the direction whereas for options the direction, the timing, and the premium must be known for one to use the options. For example, for one to buy stocks on a margin, one has to understand the timing and the magnitude. Secondly, for stocks, losses that may occur are normally a small percentage of the amount that was initially invested. Leverage of options magnifies losses when the tables turn against you, in a worst case one loses the total amount he invested. This is because one invests a higher amount larger than the using stocks as compared to options. Third, with the stock losing position, one can average down and hold over many years for it to recover to a fairer price. For options, the timing is usually short, and one can keep losing premiums the more one waits. The fourth advantage of stocks over options is that whenever an option on a stock is halted, say when the expiry date hits, problems may arise when getting exercised CITATION Fon03 \l 1033 (Fontanills, 2003). The put holders realize that there is no stock to borrow and exercise the puts while the call holders find that the brokers are not in a position to supply the stock as they cannot purchase when the trade halts. Thus, this makes the options expire worthlessly.

Advantages of options over stock

For options, the entry cost is usually lower as compared to stock. This is because its cheaper to buy options than the stock that derive their value. For instance, for a stock trading at $50 per share, for a 100 shares the cost would be $5000. In contrast to this, one at-the-money call option that will enable one to control 100 shares may cost around $200. Thus, the entry cost for the option is much lower than the cost of the stock.

Secondly, due to the low entry cost, there is a greater potential for higher percentage gains on the amount invested. That is, its easier to double $5000 as compared to $200 of investment. Third, options are...

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