Employee stock options are granted to workers by a company's management, providing an opportunity to share in a company's success in the stock market. About 9 million employees held stock options in 2008, according to the National Center for Employee Ownership, a nonprofit research organization.
Put and call options are contracts to sell or purchase a stock or other security at a particular price. They're used as a way to speculate that a security will fall or rise, or as a form of insurance, known as a hedge, on another investment.
Employee Stock Options
When a company grants stock options to an employee, it will provide the following details:
- The number of shares: This tells the employee how many shares of the company's stock he or she will be entitled to purchase under the options grant. Options may be granted by publicly traded companies or by private companies that intend to go public or be acquired one day.
- The grant price: This is the price at which the employee will be able to purchase the stock. If the grant price is lower than the market price on the day the employee exercises the option, the options are said to be "in the money." Typically, options are given the price that's quoted in the stock market on the day they are granted.
- The vesting date: This is the first date the options may be exercised. When exercising an option, the employee purchases the shares at the grant price, regardless of what price the stock is trading at that day in the market. Options must be exercised before their expiry date.
In the Money, or Under Water
Options are used as incentives to attract employees, or as is common in many technology companies, as part of a standard compensation plan for all workers. They can be very valuable, or they can expire worthless.
To illustrate these scenarios, consider an option for 1,000 shares of Widget Corp. granted on Jan. 15, 2008, when Widget shares closed for the day at $10. Under the terms of this options grant, the employee can exercise the shares no earlier than Jan. 15, 2009. On that day, if shares of Widget Corp. had risen to $30, the option would be "in the money." In other words, the employee could purchase the shares for $10, sell them immediately for $30 and net a profit of $20 per share, or $20,000. However, if the shares had fallen to $9 a share, the options would be considered "under water." That is, it wouldn't make sense to exercise the option, considering that the employee would be paying $10 for a stock that they could purchase for only $9 through their stock broker on the open market.
Watch Your Taxes
Options trigger a variety of tax consequences, so consult an accountant or read the IRS rules. One particularly painful tax mistake involves exercising options and not selling enough shares to cover a taxable gain. Consider an employee who exercises 1,000 options at $10, when the stock trades at $30. The $20,000 gain would be considered taxable income. If the stock falls back to $10 the next day, the employee would still have a significant tax hit. Many dot-com millionaires were felled by massive tax burdens they could no longer afford once their stocks tumbled.
Put and Call Options
Employee stock options can't be easily bartered, but other kinds of options are traded very actively. Options can be purchased on most stocks, giving the owner the right to buy or sell the stock at a particular price. An option to buy a stock is known as a call option. An option to sell a stock is known as a put option. Options strategies can become very complicated, and trading without the right preparation can expose the owner to an almost limitless loss. But when used knowledgeably, an option can be a very useful tool in a portfolio.
Using Put Options
Let's take the example of a person who owns 10,000 shares of a large hotel company when the shares trade at $10 each. This person believes the threat of a recession poses a risk to the company's profit, and its share price, over the next year. Rather than sell her shares, the investor may prefer to buy a put option - or the right to sell her 10,000 shares at a price of $8 at any time over the next year. While the option will cost money to purchase, it will provide protection to the investor. If the shares tumble to $5, as the person feared, she won't face the full loss. Instead, she can exercise the put option and sell the shares for $8 to the person or institution who wrote, (or "sold" in industry parlance), the put option.
Using Call Options
Take another case of an investor who believes that one of two companies that are bidding for a big government contract will prevail, and who buys shares of that company. Rather than lose out if the other company wins the contract, he purchases a call option on shares of the second company.
To illustrate this strategy in action, assume the second company (which we'll call Company B) has shares that trade for $10 today. The investor might purchase a call option for the right to buy 1,000 shares of Company B stock at $12. (The cost of the option is called a premium.) If Company B wins the contract and its shares jump to $15, the investor can exercise the call option and buy the shares at a $3 discount, and then sell them immediately for a profit. If Company A wins, as he expected, and Company B shares stay at $12, the option expires worthless.
Big Risks
Your broker may ask you to sign a release form when you trade options, because of the substantial risks in options trading. Consider the person who wrote, or sold, the call option on Company B stock referenced in the previous section. If Company B shares soar to $500 each - say it discovers a huge oil reserve under its headquarters - the option writer could be forced to purchase 1,000 shares at $500 each, and then sell them to the investor for just $12 each. That would generate a loss of $488,000!
For More Information
The Options Industry Council, an industry group that was set up to educate investors about options, provides an online tutorial on the various types of option trades.
