What is a Stock Option?
A stock option is a financial contract that gives an investor the right, but not the obligation, to buy or sell shares of a stock at a predetermined price, known as the "strike price," within a specified time frame. This financial instrument is commonly used by companies to attract and retain employees, as well as by investors looking to leverage their investment positions.
Types of Stock Options
- Call Options: These allow the holder to buy shares at the strike price before the option expires.
- Put Options: These provide the right to sell shares at the strike price before expiration.
How Stock Options Work
When an investor purchases a stock option, they pay a premium for the right to exercise the option at any time before the expiration date. If the stock price exceeds the strike price, exercising a call option can lead to profits. Conversely, if the stock price falls below the strike price for a put option, the investor can still sell at a higher price than the current market value.
Benefits and Risks
Stock options can offer substantial financial leverage, potentially leading to significant returns. However, they also carry risks, including the possibility of losing the entire premium if options expire worthless. It's important for investors to thoroughly understand these financial instruments, including their potential implications for taxes, before incorporating them into their investment strategy.