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What are Stock Options?

Options give the contract purchaser the right to buy or sell a stock at a specific price at an agreed-upon date.
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  • Written By: Damir Wallener
  • Edited By: L. S. Wynn
  • Last Modified Date: 22 September 2014
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In their simplest form, stock options are a contract between two parties that expires at an agreed-upon time in the future. The contract purchaser is buying the right, but not the obligation, to buy (a "call" option) or sell (a "put" option) an asset (the "underlying") at a specific price, on or before the agreed-upon date. The contract seller is accepting the obligation to take the other side of the transaction.

The earliest known options trade dates from 7th century BCE. Thales of Miletus speculated that the year's olive harvest would be especially bountiful, and put a deposit on every olive press in his region of Greece. The harvest was huge, demand for olive presses skyrocketed, and Thales sold his rights, or options, to the presses at substantial profit. The modern history of stock options trading begins with the 1973 establishment of the Chicago Board Options Exchange (CBOE) and the development of the Black-Scholes option pricing model.

Stock options are defined by several key characteristics. The expiration date specifies when the option contract becomes null and void. The underlying is the asset upon which the stock option is based. The strike price, or exercise price, is the price at which the underlying asset will be bought or sold should the option holder decide to exercise their right to buy or sell. European-style stock options are only exercisable on the expiration date; American-style stock options are exercisable at any time before the expiration date.

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An ATM, or at-the-money option, is one where the strike price is roughly the same as the current underlying price. An OTM, or out-of-the-money option, is one where the underlying price is far enough away from the strike price that there is no incentive for the holder to exercise the contract. Conversely, an ITM, or in-the-money option, is one where the holder can exercise the option profitably.

The simplest stock options trading strategy is to buy an OTM call (or put) option if the expectation is for a dramatic increase (or decrease) in the price of the underlying. Spreads involve buying one option and selling another; they are often used to lower the initial cost of the position at the expense of lower maximum potential profit. Examples of spreads are verticals, backspreads, bull and bear spreads, ratio spreads, butterflies, and condors.

Stock options allow speculators to make bets on market movement without having to pick an up or down direction. For example, buying both an ATM put and an ATM call would give the holder exposure to a dramatic move in either direction. Because of this, stock options traders are often said to be trading volatility rather than price.

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John57
Post 4

There are qualified and there are nonqualified stock options. It all depends on how your company has the plan set up. It is very important to know any tax consequences when dealing with stock options.

If any income is received, there will always be some kind of taxation on that income. There may be other fees or penalties depending on what your situation is.

andee
Post 3

If your company stock option is in a qualified plan, you will need to know the tax implications if you sell your option. As long as you roll it over in to another qualified plan, you should be OK. If you choose to cash it in, you will have to pay penalties and taxes on that income.

Stock options taxation can be confusing for some to understand, so just make sure you do your research and talk with a financial investment representative so you understand all of your options.

golf07
Post 2

When I worked for a bank, part of our 401K plan was an employer stock option. Upon leaving was when I needed to decide what to do with that option. This was several years ago, and the company stock was trading at a pretty good price, so I went ahead and sold the option.

Looking at the price of that stock now, I made the right decision. This was about 10 years ago and I sold it for around $60 a share. The price of the stock today is around $11 a share.

watson42
Post 1

Employees' stock options have become a cause for drama in a lot of big businesses in recent years. I suppose it makes sense, though, because if they aren't kept as pretty much fair game for people, it can get messy.

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