Before purchasing stock options it is paramount that you understand just what exactly they are and understand that in addition to the potential of making a good profit, there also exists a risk of losing a lot of money.
A stock option is the right to buy a specific number of a company’s shares during a time at a specific price that the company specifies. Many employers will offer stock options to an employee as an incentive to maximize performance, the thinking being that the more the company makes the higher the price of the stock will climb.
Stocks are different than a stock option. When you buy a stock in a company, you are essentially buying a part of the company. Let’s say a company is offering 1000 stocks total. The price of each stock is one dollar. If you were to buy one stock, you would own 1/1000th of the company. A stock option is a different scenario than this. When you purchase a stock option you are not buying any of the stock like in the example above. What you are purchasing is an option to buy that stock at some point in the future at a specific price. One may think this is a bad idea as you would not really be owning any part of the company.
The benefit however is purchasing stock options is the leverage you get with it. Here is an example. Let’s say a company is offering one hundred shares at five dollars a share. You can exercise the option January 1st 2015. When this date rolls around let’s say the price of the share as grown to ten dollars. At this point you can convert to options to stock, meaning you buy it at the five dollar price but you are able to turn around and sell the stock at its current price which is ten dollars netting you a nice little profit. Another option would be to sell a portion of the stock after the waiting period still agreeing to buy it for the five dollar a share price first.
One thing to keep in mind is that all stock options will come with an expiration date. You will have to exercise your option at some point between the starting date and the expiration date. If you fail to do this by the time the option is expired, you lose them. This is part of the risk involved with holding and waiting for them to rise.
Should you invest in stock options? That’s an individual decision and every caution must be taken when investing. There can be a lot of risk in the stock market and one should carefully consider any transaction as the potential to lose money is quite real. If a company is offering you stock options as part of a compensation package, understand that this is not always better than cash if the company does not become successful. You will need to perform careful and due diligence on the company before making a decision to accept or buy stock options.