What are stock options and how do they work?

• A stock option is a contract that gives you the right to buy or sell a stock at a certain price in the future.
• There are low- and high-risk ways to trade options.
• Employee stock options are a popular way for startups and public companies to attract and retain employees.

Stock options can refer to two very different things. The first is an agreement that can give you the option to buy or sell stock. The second is a form of equity compensation that an employer may offer prospective and current employees.

Here's what to know about stock options.

What are stock options?

A stock option is an agreement between two parties. When you purchase a stock option, you get the right - but not an obligation - to buy or sell a stock at a specific price within a certain period. If you're the option seller, you're required to fulfill the agreement based on the buyer's decision.

"Stock options allow you to benefit from a change in a company's stock in a heightened or leveraged manner," explains Yves-Marc Courtines, a financial planner and principal of Boundless Advice LLC. "The gain may be from an increase or decrease in the stock's price."

Several key terms are important to discussing and understanding how options work:

• Holders and writers: The option holder purchases the option, and the option writer sells the option.
• Exercising an option: The holder exercises an option when they decide to buy or sell the stock.
• Expiration date: The end of the potential purchase or sale period.
• Premiums: The holder pays the writer a nonrefundable premium for the option. Its value can depend on the expiration date and underlying stock's expected volatility.
• Strike or exercise price: The price that the holder can buy or sell the stock at.

American-style options let the option holder (the buyer) exercise the option at any time before the expiration date. In contrast, you can only exercise European-style options on the expiration date.

Call options versus put options

There are also two types of options: puts and calls.

• A call option means the holder can buy the stock at a specific price during a specific period.
• A put option means the holder can sell the stock at a specific price during a specific period.

You can buy or sell either type of option.

Is buying stock options risky?

Investing always involves risk, and options trading can be much riskier than buying and holding a company's stock.

"You can lose all the money you put in when you buy a stock," says Theresa Morrison, a founding partner at Beckett Collective. "If you buy or sell an option and you don't know what you're doing, you could lose the money, your car, and your house."

Investors can also use options to limit their potential losses. But you might not want to buy or sell options until you understand what you're getting into.

An example of how stock options work

"If you want to dip your toe in, you could write a covered call," says Morrison. "It means you own the stock and you write a call, meaning you sell a call."

For example, you own 500 shares of company XYZ, which trades at $80 a share, and you sell five call option contracts - each contract is for 100 shares. You collect $1.20 in premiums per share and receive $600.

The holder has the right to purchase the 500 shares from you for $85 a share (the strike price) during the next six weeks.

The holder may let the option expire if the stock's price never goes above $85. But, if it does, the holder can exercise the option, and you'll lose out on potential gains. In either case, you get to keep the $600.

Quick tip: Stock options involve risk and are not advisable for all investors. For more information, check out our guide on options trading.

What are employee stock options?

Employee stock options are a type of employee equity compensation. Companies may offer options as part of a sign-on bonus or retention program.

To draw a comparison, Morrison says, "an employee stock option is always a call option because you have the right, but not the obligation, to buy the company's shares at a fixed price during a certain period of time."

Courtines points out that, unlike traded stock options, equity offers are granted rather than purchased. Still, there's some risk involved. "What you're giving up is a paycheck," says Courtines. "Instead, you're getting an option that could be worth more, but that could also expire worthless."

You also may have to wait until an option vests before you can exercise it. For example, a portion of your option may vest each year during the first five years in a new job.

Common types of employee equity compensation

Companies can offer two types of stock options - incentive or nonqualified.

• Incentive stock options (ISOs): An ISO can offer tax advantages because your profits could be subject to the capital gains tax rate. But they can also trigger the alternative minimum tax (AMT).
• Nonqualified stock options (NSOs): Don't receive a special tax treatment. Your employer may automatically withhold income and payroll taxes. And, you'll pay ordinary income taxes on the difference between the current fair market value and your exercise price.

There are also other common types of equity compensation, but these aren't technically options.

• Restricted stock units (RSUs): Companies may offer RSUs that you'll receive based on a vesting schedule or for meeting certain goals. "RSUs look more like a cash bonus," says Courtines, "and they've become the dominant form of incentive compensation."
• Employee stock purchase plans (ESPPs): The company lets you buy its shares at a discount - often 5% to 15%.

What to ask if you're offered or have equity compensation

Equity compensation programs are a popular way for companies to attract and retain employees. Here are a few suggestions and points to consider if you're offered or receive equity compensation:

• If you receive ISOs, Morrison suggests working with a professional to create an exercise strategy and five-year plan to account for the potential tax implications.
• When you're working at a private company, you may want to hire a financial advisor who can help you determine the value of the options or equity you're offered.
• If you receive RSUs in a private company, ask if they're restricted by a liquidation event, such as an IPO or merger.
• Make sure you accept the options or equity grant - it isn't always automatic.
• You may need to actively exercise your options, or they might expire.

Also, consider how the equity impacts your entire financial position. For example, you may want to immediately sell shares from RSUs and ESPSs and use the proceeds to diversify your portfolio. Otherwise, your income and a large portion of your portfolio may be dependent on the success of a single company.

The financial takeaway

Buying and selling options contracts can be risky and should be approached with caution. But experienced traders can use options in various ways, including to limit their potential losses.

Employee stock options are completely different from options trading, but they can also be complicated. While you don't risk losing money, there's a potential opportunity cost to accepting options rather than cash compensation. You'll also want to carefully consider the tax implications of exercising your options.