It’s common in newspaper articles to read references to writing calls, buying puts, and tech companies offering lucrative stock options to employees. It’s easy to get bogged down in the terminology and be left scratching your head.
Options are an advanced topic and not something you want to recklessly get involved in. It’s very worthwhile to understand what they are, however.
History Of Future Markets
One of the oldest accounts of a futures market is about Thales of Miletus, the 6th century BC Greek philosopher. Supposedly he got sick of being asked why, if he was so smart, wasn’t he rich. The story goes that based on the spring weather he predicted that it would be a good year for olive crops. He approached the various olive oil presses and pre-purchased their entire fall capacity. The people running the presses were happy to get the guaranteed money in the spring, instead of hoping for demand in the fall. When fall came and there were bumper crops of olives, Thales was able to sell his pre-purchased presses to olive growers for a premium and became wealthy.
In a nutshell, this is how future markets (including options) work. Someone is convinced of the future such that they’re willing to commit (for payment) to some future course of action. In this case, the olive press owners committed their capacity to Thales in exchange for early payment.
Employee Stock Options
Employee stock options are perhaps the easiest to explain. A company gives their employees stock options at a particular strike price. Say I work for Google and as part of my compensation, they give me an option to buy up to 100 shares of Google stock at $2,500 per share. As of this writing, Google (Alphabet) stock is worth $2,861.80, which means every share in my option is worth $361.80 (since I can buy it for $2,500 and sell it for $2,861.80 – this is called exercising your option). If I exercised my options, I would make $36,180.00 (100 times $361.80). If Google’s share price went up, the option would become more valuable. If Google’s share price went down, the option would become less valuable.
Employee stock options often have a vesting period, which refers to a length of time where options can not be exercised. If I was granted the stock option for Google with a 6 month vesting period, it means I can’t exercise them until that time is past. This is done to ensure I stay with the company – usually, if you quit you lose unvested stock options.
This is why companies offer these. They act as “golden handcuffs” to keep employees working at the company. It also is intended to make the employee work harder, since a more profitable company will lead to a higher share price and will make them more money from their stock options.
Put and Call Options
Options just like the above can be traded on any major stock exchange. Two parties are needed, someone to write (create) the option, and someone to buy the option. The person who writes the option is acting like Google or the olive presses above, while the buyer is acting like Thales or the employee.
Say I was convinced that Google is overvalued and I expected the share price to drop. I might write (create then sell) a CALL option on Google. This means that I’m committing to sell Google stocks for a period of time, say the next 6 months (this is called the expiration date). I would also choose a strike price, which is the price I’m committing to sell Google stock for. Say I set the strike price at $2,900. Finally, it would need the number of shares I’m willing to trade, let’s assume it’s 100. This means, the person who buys the options from me can require me at any time (during the next 6 months) to sell them 100 shares of Google stock for $2,900 per share – a total sale of $290,000. If you bought this contact from me, you’d be in the same position as the employee above. At any time, you can exercise the option and immediately make the difference between the current stock price and the strike price, $361.80 per share as of this writing.
If we go to Yahoo, we can see the current value of such an option. $1,250.00 as of this writing. That means, to buy a call option for 100 shares of Google at a strike price of $2,900 would cost me $1,250.00 today. Clearly, if I bought them for $1,250.00 then immediately excised them, I would be losing money. I can sell for $2,900, but they’re only worth $2,861.80. So I’d be losing almost $40 per share, in addition to the $2,900 I paid for the option. The only reason I would buy this is if I expected Google to increase in value. If it did, I could then execute it and make money by forcing the person who sold me the option to sell me cheap Google stock. Say Google goes up to $3000.00 per share. I could then buy the 100 shares for $2,900 each, sell them for $3,000 each, making a profit of $10,000 on the 100 shares. Given that I paid $2,900 for the option, I would still be $7,100 ahead.
Say instead Google drops to $2,700.00 during the 6 months until the options expiration date. This would mean the purchaser would be losing money buying for $2,900 and selling for $2,700. This is where the name option comes from, the buyer has the OPTION to exercise it, but she’s not required to. In this situation, rather than buying the stock and losing money she would let it expire without exercising it, the person who wrote the option (me) wouldn’t have to sell her any stock and she’d be out the $2,900 paid for the option. I would still have the 100 shares of (now less valuable) Google stock ad the $2,900 she paid me.
An extra twist is that someone who buys an option can turn around and sell that option to someone else. After the option is re-sold, the new buyer then deals with the person who wrote the option. The result of this is that options are rarely exercised. Instead, they fluctuate in value based on the strike price and the stock’s current price. If someone wants to make money from an option, they’re more likely to sell it to someone else than to exercise it.
Put options work the exact same way, except that it is an obligation for the person who writes the option to BUY stock instead of selling it. Say I wrote an option saying I was willing to buy 100 shares of Google stock for $2900 per share within the next 3 months. This would work very similar to the above example, except in reverse.
One way of viewing a put option is that it’s like insurance. The person who bought it can “guarantee” that she can sell it for at least a certain amount. You’re protected against the stock price falling.
In the Money and Out of the Money
You’ll sometimes see “in the money” or “out of the money” used in relation to options. These just refer to whether or not the option could currently be profitably exercised.
Have you ever bought stock options? Have you ever gotten employee stock options? How did either work out for you?