What Is A Stock Option? (With Definition, Types And Benefits)

Updated 30 September 2022

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Stock options are a popular investment tool in the financial market. Some organisations may offer stock options to their employees in the form of bonuses or as part of their compensation. Knowing how stock options work and the benefits of employee stock options can help you choose the right compensation package and exercise your options judiciously. In this article, we discuss stock options, define employee stock options, share their benefits and explain a few important concepts to consider when exercising them.

What is a stock option?

Employees who get an offer for employee stock options (ESOs), may wonder the answer to, "What is a stock option?". A stock option is an agreement or contract between two parties that allows the buyer the right to buy or sell stocks or company shares at a predetermined price within a specified time period. These elective financial assets are a common feature of the finance world and the stock market. As stock options are a derivative of an underlying security or asset, they are a form of derivative investment instrument.

The difference in the stock price and the strike price determines the value of the option. Some organisations offer stock options to their employees as a part of their compensation package. In this manner, companies offer derivative stock options and usually give the employee the right to buy the stock at a specified price for a limited period. This is often a form of encouraging employees to participate in the company's growth and progress. The employee signs a special employee stock option agreement that explains the terms and conditions of the contract when the company grants them stock options.

Different types of stock options

In the standard exchange-traded or listed stock options, there are two types of stock options:

Call options: This is when the buyer or investor expects the value of the stock to increase in the future. An investor can buy the asset or stock at a predetermined price within a specific timeframe once it reaches the strike price.
Put options: Put options are investments that benefit the buyer when the value of the asset or stock decreases in the future. An investor can sell the asset or stock at a predetermined price within a specific timeframe to earn a profit.

Other essential stock options concepts

Other than call and put, there are a few other crucial concepts in stock options trading:

Expiration date

This is the set date when the investor expects the value to increase or decrease. Studying market trends and analysing historical performance is important before deciding the expiration date. Depending on the option type, you can earn a profit by exercising your option and choosing an expiration date by anticipating and speculating when the asset value will rise or fall.

Strike price

The strike price is the predetermined price that the investor thinks the stock will reach by the expiration date. When the buyer or investor believes that the price of a certain stock will increase in the future, they may purchase a call option at a price higher than the current market value or the strike price. When the stock reaches ‘in the money', or the strike price, the investor can exercise the stock option to make a profit.

Premium

The premium is the price of the stock paid for an option. You can calculate the premium by multiplying the number of contracts with the price of the call and then multiplying it by 100. If the options expire without realising any value, the investor would lose all the investment they make into buying the option. This amount is the premium.

Contract size

Contracts are the number of shares in the option, and one contract is 100 shares of stock. Investors and buyers can call or put as many contracts as they wish, depending on their risk appetite and confidence in the future performance of certain stocks. If a trader purchases call options for 500 stocks of a certain company, they would have purchased five call contracts.

What are employee stock options?

Organisations may offer equity-based compensation to their employees in the form of stock options. Companies grant employee stock options with the expectation that when the value of the stock rises in the future, employees can purchase it at discounted rates. Unlike other listed or traded stock options, you cannot sell these options. Once the price rises above the stake price, employees can purchase the company stock at a discount price, regardless of the actual price. They can then sell this stock immediately in the open market to earn a profit or continue owning the shares.

Employee stock options, or ESOs, are typically available with the following restrictions:

Limited employees: Organisations may offer stock options to only some employees.
Set number of shares: ESOs usually constitute a limited number of shares as a percentage of the total number of company shares.
Specific price: Employees may get options different from that available to the public.
Defined time period: The duration of the stock option can vary as per the number of shares or for each employee.

Benefits of employee stock options

Companies may offer employee stock options for several reasons, including:

Attracting talent: a higher compensation may attract top talent to the organisation
Increasing retention: high-performing employees who get stock options with rewards may be less likely to leave
Promoting ownership: cultivating a sense of ownership in employees
Rewarding success: offering stock options can help incentivise employees to work efficiently

Factors to consider while exercising stock options

Here are some factors to help you decide how and when to exercise your employee stock options:

Current financial status

If you require a high amount of cash and your stock options have a positive value, you can exercise your options. This can be particularly helpful if you have a high loan amount to repay or if you require to make a down payment. You can also exercise them during other unexpected emergencies, such as a medical emergency. If you are pursuing higher education or have to relocate, you can consider exercising your stock options to have higher availability of capital.

Prevailing marketing trends

If you think that investing in another stock can be more profitable, you can exercise your options and reinvest the capital. Exercising your stock options can also be important to maximise your profit or minimise your loss if the company is performing poorly and you have no faith that its performance can improve in the future. You can also consider the macro-economic trends in the economy to evaluate the volatility in the stock market. If a crash is imminent, you can exercise your options and diversify your investment to minimise the impact.

Taxes and financial planning

The gains from selling company stock can increase your tax liability. By planning your projected income and deductions in the future, you can choose the right time to exercise your stock options. For example, if you exercise all your options together, your tax liability in that particular year may increase significantly. You can consult a financial planner or accountant to identify the right time to exercise employee stock options to ensure maximum profit and minimum tax liability. Doing so can also help determine how to reinvest or manage the capital smartly.

Essential employee stock options concepts and definitions

Here are some key terms and concepts related to employee stock options:

Plan or agreement: The ESO plan or agreement includes all the terms and conditions of your stock options, the process to exercise them and other import information, like the price and vesting period.
Grant price: The special discounted rate at which an employee can get the stocks in the future.
Market price: This is the actual current value of the stocks in the existing marketing conditions for the stocks in the ESO.
Spread: This is the difference between the actual price of the stock in the market and the grant price.
Issue date: The date at which the company grants the employee stock options is the issue date and usually the start date of the plan or agreement.
Vesting: This is the time period which takes for the stock options to become active. Additional conditions relating to the duration of the employment may also apply.
Vesting date: This is the date when the employee can begin to exercise their stock options.
Exercise date: The date when the employee exercises their stock options and makes any transaction. This date is between the vesting date and the expiration date.
Expiration date: The date until which the plan or agreement is valid and the employee can exercise their stock options.
Reload option: The provision to grant an additional stock option to the employee when they exercise their current options.