Stock Options: A Beginner’s Guide

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Stock options are a mystery for most casual investors. You may have heard of this during 2021 when everyone was a buzz about shorting GameStop stock.

What in the world does that mean? Well, it is about stock options, which is basically a bet that a stock will do better or worse in the future. We will cover what stock options are and what sort of risk tolerance you need to do them.

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These ideas are based on my personal experience and opinion and should not be considered professional financial investment advice. Furthermore, the ideas and strategies should never be used without first assessing your own personal and financial situation, or without consulting a financial professional.

What is a stock option?

A stock option is a contract that gives the holder the right to buy or sell shares of a corporation’s stock at a set price within a certain period of time. Stock options are used as a way to incentivize and reward employees, but they can also be bought and sold by investors as a speculative bet on the future direction of a company’s stock price.

Stock options are typically issued with an exercise price that is equal to or slightly below the market price of the underlying stock on the date of grant. The holder of a stock option has the right, but not the obligation, to buy or sell shares of stock at the exercise price. If the stock price rises above the exercise price, the option is “in the money” and has intrinsic value.

If you are using stock options for stock not connected to a company you work for then it is important to focus on the words “speculative bet” in the definition. YOu are gambling that

How does a stock option work?

Options contracts are typically for 100 shares of the underlying stock, but they can also be for more or less. The price at which the option can be exercised is called the strike price. The expiration date is the last day that the option can be exercised. Now there are different types of stock options and the differences are very key.

What are examples of stock options?

There are calls and puts. A call is an option to buy at a set price. A put is an option to sell at a set price.

For example, you believe that a well-known stock will have a bad quarterly return so you place a call option to buy them at a set price (let’s say you want to buy 50 shares at $20 each and the stock is currently trading at $25). If in the next 90 days the stock hits that price you have instructed your option to exercise the option at the strike price. At that time you would spend $1000 and buy 50 shares of that stock.

Let’s say you think they will go up because they had a great quarter. So you will place a put option to sell your 50 shares at $30 each or in 90 days. If they don’t hit the $30 in 90 days then the option expires and you still have your stock.

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Are options better than stock?

Stock is bought and sold at set prices. Options are bought and sold and potential future prices.

The difference is simply this. I buy stock in Acme corp and they have a horrible year and their stock price tumbled over 5 months to be 100% worthless. I am not out the amount of money I invested or sold at a loss in those last 5 months.

I buy a put option in Acme corp on 100 shares but the stock fell much much faster than I thought it would. When the price hit $1 someone forced me to sell my shares at $1 but I had paid $20 each for them. Or it could go the other way as it did with GameStop.

You see some big companies decided to short GameStop and people found out about it. So they decided to create a run on GameStop, meaning they told everyone to BUY BUY BUY!!!!

And they did. So if you were betting that GameStop stock was going to be worth $3 and you would sell 100 (or worse 10,000) shares of GameStop for $3 a share and all of a sudden it was now going for $180 or more a share you are going to lose $17,700 for 100 shares.

In January 2021 alone 8 hedge funds lost $19.75 billion dollars due to stock options.

Knowing this if you pick the wrong stock and buy it you are out at most of the money you spent. With options, you could lose your home and all your assets. Especially if you bet 10,000 shares that you didn’t own hoping to buy them for $2 and sell them for $3 each and make $10,000, but instead the stock goes to $100 overnight and now you need to buy $1,000,000 of GameStop to sell at $20,000. Assuming you even have the assets to liquidate for a $1,000,000 purchase you would then lose $980,000 just like that.

Are stock options worth it?

Personally, I stay away from options. Yes, there are some scenarios where it could make sense but frankly, I am not sure that the potential rewards outweigh the potentially infinite downside.

Do you pay taxes on stock options?

Yes. All stock trading falls under Capital Gains taxation in the United States. So if you make money from options then you will be taxed based on whether or not you owned that stock for a year and a day or less. There are two tax tables. One is for longer-term investments (lower taxes) and the other is for short-term investments (higher taxes). The tax tables can be found on the IRS website here.

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What is the difference between stock options and employee stock options?

We covered stock options in-depth above, but what about employee stock options? Well if you work for a company that is publicly traded they may allow you spent a percentage of your paycheck to buy company stock. The company stock is normally offered at a discount of 10% – 15% off of the listing price at a certain date. Some companies only allow you to join this program once or twice a year.

Also, there are rules that the company has to follow to set the price and then take off the 10% – 15%. I have seen some companies set the rate at the close of business on the last trading day of the month for the next month. I have seen some companies set this up quarterly. Regardless, there will be a period of time when getting 10% – 15% off the price from a month ago may not be in your best interest.

Should I buy employee stock options?

So before you enroll look at the history of your company’s stock price to see if it goes up or down over time. You may be getting 10% off if you just wait a month. This might be ok if your company pays out good dividend bonuses quarterly, but the choice is yours or not if you want to invest in your company’s stock. A dividend is a cash payment that is typically paid by some companies to share profit with their shareholders. They will give a specific amount for each share you own. So if they were to give $1 a share and you owned 100 shares you would receive $100.

Most of the time these dividends are set up to reinvest (i.e. buy more) into the stock that paid out the dividend, allowing you to get more stock for bigger dividends. This assumes your company will be around for a while. I would suggest no more than 5% (and really 2% or less) of your annual pay into one of these employee stock options.

How Can You Succeed Financially?

There is a clear path toward financial success and security.

It isn’t just being a worker for 45 years. Although for some it may involve that.

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Options can be useful but are riskier than stocks

If you are risk-averse at all then options are a bad idea. If you have a high-risk tolerance like I do then do more research to see if stock options are right for you.

Personally, I don’t feel like I know enough to feel comfortable with them, and seeing 8 multi-billion dollar hedge funds lose over $19 billion in one month is enough to make me very nervous.

As for employee stock options it may or may not be a good idea depending on the future of your company. Do you feel they are on the right path and will be around for another 20 – 40 years? Then look into buying them if that is what you want to spend your money on. If you don’t believe in the future of the company then put your money elsewhere.

If you need to know where to put the rest of your money please read my article on money management tips for high income earners.

Wow, you read a lot to get here. Can you do me a favor, please? Can you leave a comment if this was helpful to you or if I missed something? Alternatively, it would help me out a lot if you shared this content with those that might need to see it. Thanks, you are the best!

About Dwight Scull

I have been married to my wonderful wife, Rebecca, who puts up with me since 1999. I am a proud father to my Gen Z, son, and daughter-in-law. Grandfather to my favorite granddaughter who was born in 2021.

I lost my mom, father-in-law, and 12 others in 2013 and was DEEPLY in debt. I started reading and watching all the financial info I could find.

I chipped away at my debt and went from a negative $105k net worth having one home paid off, no credit card debt, and saving/investing 45%+ of my gross salary.

I used these daily habits to lose 100 pounds and keep it off.

I believe that you can overcome any challenge you face if you just take small daily actions and be consistent with them. It is how you will be financially successful.

Join my free Facebook group to get a ton of free resources to help you get out of debt, learn how to invest your money and work toward having the option of retiring early.

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