A stock option, or share option is a type of contract, which grants the right, but not the obligation, to purchase or sell a stock at a specific price, for a specific length of time. American stock options can be exercised at any time during the contract, while European options can only be exercised during a particular time before the contract expires.
Stock options are generally classified either as exchange-traded options, which are traded on the markets, or employee stock options, which are often given as part of an overall compensation package. Both these types of options share the same basic features, but do have some differences.
The basic idea behind both types of stock options is that an investor can purchase a stock for a specified price, at any time during the option period, and then sell the stock at market value, possibly for more than they paid. This is called exercising the option. Stock options eliminate a good deal of risk for investors, who do not have to purchase any of the stock until they know if it will be to their benefit.
If you purchase an option to buy a set number of shares in ABCD Company at $100/share, for example, and the stock reaches $150/share during your option period, you could buy and then resell it at a handy profit. But if the market value drops below your option price, you have no obligation to purchase the stock, and suffer no loss beyond the purchase of the option itself.
Stock Options for the Individual Investor
As easy as that all sounds, there is a lot of terminology about stock options that an individual investor should understand before diving into the option game. For example, the option itself is referred to as a call, and a covered call refers to the strategy of holding on to the option for a long period of time. The term contract refers to an option for 100 shares of the underlying stock, and a sell is called a strike. An option that is at- the-money, means the market value is the same as the option price. In-the-money means the market value is higher.
Luckily, there are many resources out there for the individual investor, to clarify the option buying or selling process. You can talk with your broker, or check your online brokerage if you use one, to make sure you have all the facts you need. Tutorials from financial websites, such as Investopedia.com, can also provide more in-depth information.
Employee Stock Options
Long considered a reward for executives only, employee stock options (ESOs) have become a much more common piece of compensation packages for corporations in the U.S. Because ESOs usually require a set length of employment before they can be exercised, they provide an incentive for workers to stay until they are vested. And because the company can expense the cost of the options at the exercise price, they provide the chance for a higher benefit for their employees, and the company gets to retain more of its cash.
Employee stock options vary from exchange-traded options in several ways. Because they are a private agreement between a company and an employee, the standard contract of 100 share units may not apply. Instead, the amount of shares is often determined by the employee’s job title, salary range, or job performance.
The timeframe for the option contract is also apt to be considerably longer than one would see on an exchange-option, running as long as 10 years. If options are awarded as part of an annual bonus, or salary reviews, then the vesting rules may apply to each year’s option differently.
For example, an employee might have worked for a company for seven years, and received stock options for six of those years. If the company has a vesting rule of five years that might mean all the share options are vested based on the employee’s length of service, or it might mean that only the options that have been in place five years can be exercised 100%. Some companies may offer a graduated percentage of the options for less than the vested period, others may offer none at all.
Another difference between ESOs and exchange-traded options is that ESOs are usually non-transferrable. Only the employee has the right to exercise the option.
Even though there are fewer risks from options than from simply buying stocks, an employee could still exercise his options too soon to make a profit, or hold them too long, and see the stock lose value. If one’s employer suffers significant losses, an employee could find that the reward promised with stock options is worth very little at all. For this reason, some employees may decide to exercise their options as soon as possible, and diversify instead.