What are stock options, and how do they work?
As you increase your financial literacy and step further into the investing world, you’ll soon come across the concept of stock options.
What are stock options?
A stock option, also known as an equity option, is a type of contract. If you have a stock option, you can buy or sell an asset on or by a specific date and for a certain price, but you don’t have to do this. Essentially, stock options represent potential opportunities to make money.
According to the Washington Post, 61% of Americans now own stocks. This is the highest level of investment interest the country has seen since 2008, and more people are getting into the world of stocks and shares with every passing day.
How do stock options work?
Generally, one stock option represents 100 shares of the stock in question. In the investor market, there are two main different types of stock options in play:
Call options – call options bet that the stock will rise in value and give the option holder the right to buy at a set price within a named timeframe.
Put options – put options bet that the stock will fall in value and give the option holder the right to sell at a set price within a named timeframe.
Stock options of these two types are traded on several exchanges, including the International Securities Exchange and the Chicago Board Options Exchange. In some cases, multiple options will be traded at once in what’s known as an “options spread.”
What are Employee Stock Options (ESOs)?
You may have heard of stock options in the context of employers and employees, as it’s common for new companies, especially startups in industries like tech, to offer their employees stock options as a benefit. This amounts to a call option and is commonly referred to as an Employee Stock Option (ESO).
In the context of an ESO, stock options function as a form of compensation. Employees can buy a specific number of shares at a set price after they’ve been with the company for a certain amount of time – if they choose to. In the best-case scenario, this means they’ll be able to profit as the value of the company’s stock goes up.
ESOs are either ISOs, incentive stock options, or NSOs, non-qualified stock options, with ISOs more likely to receive special tax treatment.
The pros and cons of stock options
Whether you’re considering a job that comes with employee stock options or hoping to start investing in this area with the help of your financial advisor, it’s important to note that there are pros and cons to this sort of financial instrument.
| The challenges of owning stock options | The advantages of owning stock options |
|---|---|
| Investors buying options will be charged a premium to do so and could lose this money if things don’t go as planned in market terms. | Stock options aren’t a huge financial commitment, as buying or selling is not imperative if the market doesn’t align with expectations. |
| There’s never total certainty that a stock will move as predicted, and you’re never guaranteed anything – your options will be worthless once they expire. | Just as there are plenty of available stocks to invest in, there are plenty of available stock options – you’re free to align these with your values and investment strategy. |
| Stock options are undeniably complicated for a beginner to get their head around, complete with many rules and niche terms that might send your head spinning. | If you have a trusted financial advisor in your corner, they’ll help you understand and get involved in the world of stock options if it truly feels suitable for you. |
| Especially when being offered to employees by a company in its infancy, stock options can take many years to turn into money in your pocket. | Some stock options employers offer to their employees come with valuable tax benefits that help maximize savings and delay taxation until stocks are sold. |
How are stock options taxed?
Options become taxable only when they’ve expired or been acted upon.
For investors actively trading call and put options, any profits at the end of each tax year will be subject to income tax and capital gains tax. Depending on how long you hold the stock options, their income could be classified as short or long-term and taxed accordingly.
As for employee stock options, NSOs are taxed as above, but ISOs are slightly more helpful from a financial standpoint, as they aren’t taxed until the point at which the options owner sells their shares. This means that when they sell, and those taxes are due, the employee can at least cover the amount with the sale proceeds.
Whether you’re an employee likely to receive stock options or an investor looking into becoming an options trader, there are pros and cons to consider.
Consider speaking with a qualified financial advisor to align your investments and financial behaviors with your long-term life goals. Reach out to Unbiased today to connect with a financial advisor who can listen and offer advice based on your situation.
Senior Content Writer
Rachel is a Senior Content Writer at Unbiased. She has nearly a decade of experience writing and producing content across a range of different sectors.