What Are Stock Options?
We are commonly asked, “What are stock options?” Being in the financial “game” for so long, we forget that the majority of folks out there really don’t understand investment terms, much less fairly complicated terms and instruments such as stock options. With that in mind, here is a brief explanation and description of what stock options are. If you would like to add to this simplified definition, please feel free to do so.
The simplest stock option definition is simply that it gives the holder the right to buy or sell stock at a specified price by a specific date. In other words, the person that purchases a stock option may choose to purchase or sell the underlying instrument (the “stock” itself) in the future, for an amount that is determined when the option is granted by the seller.
Let’s put this working definition into a practical explanation. Pretend that Mary owns 100 shares of Google stock. Let’s say that Google’s stock is currently valued at $500 a share. Now Ben approaches approaches Mary and inquires about entering into an options contract for her Google stock. They both agree that Ben will have 10 days to purchase all of Mary’s shares in Google for $500 each. For entering into this contract, Ben immediately pays Mary $1 per share ($100).
If 10 days go by and Ben does not execute upon the agreement, this stock option contract will expire and Mary gets to keep her Google shares, along with the $100 profit.
If they are in the US, Ben can execute the options contract at any time before it expires by simply purchasing the shares or selling them. If they are in Europe, Ben can only execute upon the agreement on the 10th day.
Why would Ben want to purchase or sell the Google stocks? Because Google’s stock prices went up! Let’s say that on the 8th day Google’s shares were trading for $600. Ben could immediately act upon the stock options agreement and sell all of the shares on the market, which would yield him a return of $100 per share (minus any fees).
Why would Ben not want to purchase or sell the shares of Google? Because the price has fallen! Let’s say that the value of Google stock has fallen to $400 on the open market. If Ben acted upon the stock option he would be a fool because he would have to pay Mary $500 a share, while he could purchase the same stocks on the open market for only $400! In this example, Ben would just let the option expire and count the $100 cost as a sunken expense.
Hopefully this answers “What are stock options?” for you. We realize that it is simplistic, but we all need to start from somewhere. We gladly welcome any thoughts, additions, questions, or comments that you may have. Thank you very much for visiting us today.
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Tags: google, investments, options, shares, stock options, stocks
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August 14th, 2008 at 8:59 am
Very nice site you have here. I’m looking forward to some more investment advice from you guys. this explanation of what a stock option is was EXTREMELY helpful to me. Thank you!!
Jim L. from Chicago
August 14th, 2008 at 11:04 am
Yes great article explaining stock options, i recently became interested in stocks, bonds, trading and different investments. There’s a lot to learn, but i believe with a bit of research i will be able to make money with stocks if i make the right choices.
I don’t expect to get rich fast with stock options, but i hope to be able to retire with some smart trading.
Looking forward to more great articles.
Thanks, Mark.