Stock options are a contractual agreement that give the option holder the right to purchase a specified number of shares of stock in a corporation at a specified price within a specified period of time. Stock options are typically used either as a means of retaining and compensating key employees (employee stock options) or as an investment vehicle for speculation or as a hedge against loss.
Employee stock options
Employers frequently use employee stock options as a device to retain and compensate key employees. Stock options were once the domain of corporate executives and technology start ups; however, corporations now frequently grant employee stock options to key employees at all levels. Employee stock options are a contract between an employer and employee which allows the employee to buy a specific number of shares of the employer’s stock at a set price. Employee stock options usually have a deadline by which the options must be exercised. If the employee does not exercise the options by the deadline, then the options expire.
An employee profits from employee stock options if the the market price of the employer’s stock increases between the time that the employee receives the options and the deadline for exercising the options. If the price of the employer’s stock increases during the option period, then the employee can exercise the option and purchase the shares at the option price. The employee can then either resell the shares and take an immediate profit from the sale or elect to retain the shares of stock as an investment.
For example, assume that an employer grants an employee an option to purchase 1,000 shares of the employer’s stock at $10 per share. On the option’s exercise date, the market value of the employer’s stock is $30 per share. The employee elects to exercise the option and pays the employer $10,000 to purchase the stock. The employee then sells the stock on the open market at the current market value of $30 per share. The employee realizes $30,000 from the sale of the stock, leaving the employee with a $20,000 profit.
Stock options as an investment tool
Stock options are also used as an investment vehicle by some investors. One common use of stock options is to provide a shareholder with a hedge against a decline in the market value of the the shareholder’s stock. A shareholder who fears that his investment will decline in value, can purchase a put option which allows the shareholder to sell a specified number of shares at a specified price.
If the market value of the stock declines below the option price, then the shareholder can elect to exercise the option and sell the stock at the option price, thus limiting the shareholder’s loss on the sale of the stock to the purchase price paid by the shareholder to purchase the stock plus the premium paid to purchase the option less that option price. If the market value of the stock does not decline below the option price, then the investor can allow the option to expire and the shareholder’s loss will be limited to the option premium.
Call options can also be a useful vehicle to allow an investor who believes that a corporation’s stock will increase in value to profit from the increase in value without having to incur the risk of first purchasing the corporation’s stock. A call option grants the option holder the right to purchase a specified number of shares in a corporation for a specified price.
If the market price of the stock rises above the option price, then the investor will exercise the option and purchase the stock. If the market price is below the option price, then the investor will allow the option to expire. If the investor exercises the option, then the investor’s profit will be equal to the market price of the stock less the option price plus the option premium paid to purchase the option. If the investor declines to exercise the option, then the investors loss is the amount of the option premium.
In addition to buying options, investors can also write or sell options. Writing options frequently involves substantial risk of loss and is not appropriate for most investors. An investor who writes a call option is agreeing to sell a specified number of shares of stock to the option holder at the option price. If the option expires without being exercised, then the investor’s profit is the option premium received for selling the option. If the option is exercised, then the investors loss equals the amount which the investor paid for the stock less the option price plus the option premium.
Similarly, an investor who writes a put option is also exposed to a substantial risk of loss. An investor writing a put option is agreeing to purchase a set number of shares of stock at the option price from the option holder. The investor will make a profit equal to the option premium received if the option is not exercised. If, however, the option is exercised, then the investor’s loss is equal to the option price less the market value of the stock plus the option premium received.
In conclusion, employee stock options provide employer’s with a mechanism for compensating and retaining valuable employees. Stock options can also be a valuable tool for investors looking to limit their exposure to losses resulting from changes in market value. Additionally, stock options can also provide investors with a way to speculate on the future price of a corporation’s stock without having to tie up their money by purchasing the corporation’s stock and waiting for the stock to appreciate in value.