Stock options are a form of speculative investment related to predicting how the price of a specific stock will rise or fall in a given period. While options can provide great return, they can also cost you money if you don’t exercise them in the specified time frame. Stock options can be confusing, so you may want to consult an investment adviser before buying or selling.
Stock options are basically an agreement or contract between two parties that expires on a specific date. The purchaser of the contract has the right, but not the obligation, to buy or sell a certain stock at a specific price at any time before the expiration date. The seller of the contract agrees to comply with the buyer’s wishes if she exercise her option. If the buyer lets the expiration date pass, the contract expires unexercised.
Imagine you find your dream house, but can’t afford the purchase price of $300,000 for another two months. For $3,000, the seller may offer to sell you the house for $300,000 at any time in the next two months. Now imagine a gold mine is discovered in the back yard, and the property is now worth $1 million. You could immediately purchase the house for $300,000 and sell it at a profit of $697,000 (the new value, minus the purchase price and the cost of the option).
Now picture the same scenario, except that the house is built on a sinkhole that will cause it to fall into a toxic waste dump in six months. You have the right, but not the obligation, to purchase the house at the agreed upon price. In this case, you could let the option expire unexercised, and instead of spending $300,000 on a now worthless house, you’ll only be out the $3000 you paid for the option contract.
Stock options allow you to hedge your bets against sudden turns in the market. For example, if you expect the stock market to rise substantially, you can purchase options to buy stock at today’s lower prices, but can let the contract expire unexercised if the market takes a sudden downturn. By the same token, you can purchase an option to sell stock to another investor at today’s higher prices if you expect the market to go down.
Some companies will offer employee stock options, particularly to attract or retain talented employees, if the company expects its stock to rise substantially in the near future. These options offer employees the right, but not the obligation, to purchase company stock at lower prices, with the expectation of high returns. If you expect your employer’s stock to rise, this may be a good idea. However, if you are unsure how the company will perform, you may wish to let your options expire unexercised.
Ben Bontekoe is a published writer with an extensive background in personal finance, banking, career counseling and education. A graduate of Calvin College, he has worked for major financial institutions including Bank of America and Citibank.