Explain Stock Options
Have you heard about Stock Options but you’re not sure what they are?
Do you want someone to explain stock options to you like you were a five year old?
That’s literally what I googled the first time I tried to figure them out.
So today I’m returning that favour and showing you exactly what stock options are.
Stock Options Explained
A stock option is a contract that gives the buyer the right but not the obligation, to buy or sell shares of stock (in 100 share increments) at an agreed-upon price on or before a defined expiration date.
The seller of an option contract is paid to take on the risk of either potentially having to purchase shares at the agreed-upon price or potentially having to sell shares at the agreed-upon price.
A little overwhelming?
Don’t worry, I’ll go 5-year old mode in a second. Let’s just cover a couple more things…
There are two types of stock options:
Call Options
A Call Option gives the buyer the right to purchase 100 shares of stock from the seller at the agreed-upon price.
The seller gets paid cash (known as premium) immediately to sell the call option to the buyer and takes on the risk of having to sell 100 shares of stock to the buyer at the agreed-upon price.
Put Options
A Put Option gives the buyer the right to sell 100 shares of stock to the seller at the agreed-upon price.
The seller gets paid cash (again immediately) to sell the put option to the buyer and takes on the risk of having to buy 100 shares of stock from the buyer at the agreed-upon price.
Stock Options Expiration Date
Every stock option contract has an expiration date. This governs the contract as is the last possible date that the contract is valid.
On the expiration date, the buyer of an option contract has the ability to exercise the contract and either buy or sell shares to the seller.
However, if the expiration date passes and nothing is done with the contract it will expire worthless.
Strike Price
Explain Stock Options For Dummies
Ok, so here is 5-year old version, or close as I can get to that.
You know how you pay for insurance each month?
Let’s take life insurance for example and compare it to a put option.
And let’s say you pay your insurance company $50 per month for your insurance policy which is valued at $500,000.
If you are healthy and nothing happens over the course of the month you would have paid $50 and received no return on that money (good health aside!).
The insurance company gets paid that $50 and for the month, take on the risk that you may be injured and forced to put in a claim on your insurance policy.
At which point, they would have to pay the $500,000 to cover some form of medical expenses.
So you as the ‘Buyer’ are paying for the protection of your health, and the insurance company as the ‘Seller’ are getting paid for taking on the risk of potentially having to buy you healthcare if something goes wrong.
The contract is in effect for one month and the next month you would pay another $50 to insure your health for another 30 days.
The agreed-upon value or strike price of the contract is $500,000 which the insurance company would have to pay in the event of a claim.
Stock Options Explained As Insurance
This is exactly how a put option contract works.
The buyer (you) of a put option pays the seller (insurance company) the $50 of cash (premium) for 30 days (expiration) of coverage in the amount (strike) of $500,000.
When you buy a put option in the stock market, you are buying insurance.
If nothing happens over that 30 day period, you lose the $50, but if the markets are injured and decline (just like you in the healthcare example) then you get to put in a claim and get paid $500,000.
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