Employee and Company Stock Options
Exchange Traded Calls and Puts
Definition of Stock Options:
The words "Stock Options" have two similar buy slightly distinct meanings in everyday use. The first use is in the sense of employee stock options. An employee stock option usually grants the employee the right to buy a certain number of shares of the company at a discounted price in the future. Companies frequently issue Stock Options to employees for a variety of reasons. Employee stock options are given to employees:
- as an incentive for the employee to help improve the company's profitability
- to encourage them to stay with that company
- to help improve the employee's loyalty and commitment, and
- to give them a sense (however small it might really be) of ownership.
Exchange Traded Options
The stock markets have created exchanges that trade "Stock Options." These stock options come in two types. There are call options, which are the right to buy shares of a stock at a certain price by a certain date. And there are put options, which are the right to sell shares of a stock at a certain price by a certain date.
In every day language, an option is defined as "the power or right of choosing, or something that might be chosen." As it relates to stock options, there are two types of stock options--there are stock options that are "calls" and there are stock options that are "puts". Employee stock options are always call options.
Stock options are defined by 4 characteristics:
- There is an underlying stock
- There is an expiration date of the option
- There is a strike price of the option
- The option is either the right to buy or the right to sell (call and put, respectively)
The difference between calls and puts is the owner of a call option has the right to BUY a stock at a certain price. The owner of a put option has the right to SELL a stock at a certain price.
They are called stock options (emphasis on the word "option") because when you own stock options you have a choice as to whether or not you want to exercise the stock options. For example, when you have a call option you have the choice to buy the stock at that certain price by the expiration date (obviously if the current market price of the stock is less than the strike price of the call option, then you would not exercise the call option and you would not buy the stock).
Likewise, when you have a put option you have the choice to sell the stock at the strike price by the expiration date (obviously if the current market price of the stock is higher than the strike price of the put option, then you would not exercise the put option and you would not sell the stock at the lower price). For call and put option, if you choose to buy the stock (or sell it if you have a put), it is called "exercising" the stock options. If you choose not to buy the stock, the stock options are said to have "expired."
Example of Stock Options
Stock options became popular as incentives to employees of publicly traded companies. If you worked at IBM and IBM stock was at $90 a share, you might have been given stock options to buy 100 shares of the IBM stock at $95 a share by December. Since the stock was currently at $90 and you had an right to buy the stock at $95, the option is worthless.
The idea with employee stock options is that owning them does provide an incentive for you to help get the stock up to $100. If in December the stock is less than $95 you would never exercise your call and buy the stock--it would just expire worthless; but if the stock was at $95.01 or higher then you would exercise it and buy the stock at $95. Now you see why it is an "option". For call options, if the stock price is below the "exercise" price then you don't have to, nor should you, exercise it.
Here are the top 10 option concepts you should understand before making your first real trade: