Stock Option

What Is a Stock Option?

A stock option is a contract that gives the buyer the right, but not the obligation, to trade a stock at a predetermined price within a specific period. The fixed price is called the strike price, and the deadline is the expiration date. Options come in two main forms: a call option, which gives the right to buy, and a put option, which gives the right to sell. The term also describes equity compensation that companies grant to employees, covered below.

How Exchange-Traded Options Work

Options are derivative instruments, meaning their value depends on an underlying asset, here a stock. The buyer pays a premium to the seller for this right. If the stock moves beyond the strike price in the holder's favor, the option is said to be "in the money" and may be worth exercising. If it does not, the holder can let the option expire, losing the premium paid. In the United States, a standard listed equity option usually covers 100 shares, so the quoted price per share is multiplied by 100 to get the cost of one contract.

Consider a stock trading at 50 with a call option whose strike price is 55 and whose premium is 2 per share. One contract costs 200 (2 × 100). At expiration, the position breaks even when the stock reaches 57, the strike plus the premium. Below that level, the holder loses some or all of the premium. Above it, the position gains value.

Employee Stock Options

Companies often grant employees options to buy company shares at a price set on the grant date, with the aim of aligning employees' interests with those of shareholders. These options usually vesting over time, meaning they can be exercised only after the employee has remained with the company for a set period. In the United States, two common types are the incentive stock option and the non-qualified stock option, which receive different tax treatment. Tax rules for both are complex and depend on individual circumstances.

Why It Matters

Option values can change quickly, and an option that expires out of the money has no value. Holders can lose the entire premium they paid. For employees, unexercised options may be worth nothing if the stock stays below the strike price. Understanding the strike price, expiration date, and vesting terms is essential to knowing what an option is actually worth.