How Do Stock Options Work?

Employee Stock Options: The Primer

Options? Strikes? Calls? If your mind is whirling with esoteric terminology, let our guide assist you.

 

Options contracts aren’t new, and we don’t even mean the “less than 100 years old” kind of new. In his book Politics ¹, Aristotle describes a bet made by Thales of Miletus, a 5th century BC Greek mathematician, astronomer, and philosopher.

According to Aristotle, Thales used the stars to predict a bumper olive crop, then bought up options to rent all the olive oil presses across the region and established a monopoly.

Thales walked on this earth 25 centuries ago, but his story still has some lessons to teach us about options today. In certain circumstances, options can be risky, but they are powerful financial instruments that give you the ability to take targeted risks.

If you are new to stock options, and especially if you are wondering what to do with employee stock options and whether there are any risks, read on to find out what made Thales such a savvy businessman and discover a deeper understanding of your own employee stock options.

We’ll start by introducing the concept of options as financial instruments, put them in a historical context, and go over the different terminologies used to talk about options. We’ll conclude by discussing the factors that make your stock options valuable.

This post is the first part of my comprehensive series on all you need to know about employee stock options.

In future posts, we’ll address other aspects of employee stock options—vesting, taxation, what your options might be worth, how to exercise them, and, of course, strategies for the best time to exercise your options and how to balance the risks of options and other investments in your portfolio.

 

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Introduction (The essentials of stock options you need to know)
Thales of Miletus reads the stars (How to use options)
A London Exchange’s “corner” (Why options might be risky)
Are we “In” or are we “Out”? (How to talk about your options)
The two parts of an option’s value (What drives the value of an option)
Parting thoughts

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Introduction

The essentials of stock options you need to know

If you’re reading this, you probably have employee stock options and look for deeper insight into how these things work.

Before we get back to Thales, let me first say that the concept of options goes far beyond the notion of employee stock options. Employee stock options are but one specific kind of option in the vast universe of “options” in general. Here, we’ll stay close to employee stock options, but we’ll also discuss the larger context to help you understand their value.

We’ll start with some key terms that link employee stock to the bigger picture. So, what is an option?

A general term for options and option-like contracts is contingent claims. They are called “contingent” because their value depends on something happening or not happening in the future. Whether it’s the price of a stock going up or down, or staying where it is, or harvest turning out plentiful or ruined by locusts — there is no limit to what these claims can cover.

While this term is not the most common, it provides a good idea of the overall gist of options in general.

Simply put, an option contract gives its owner — the option buyer — a right to purchase an asset at a preset price, called a strike price, even if that price has risen later. The counterparty to this contract is the option seller or the option writer. This option may be contingent on any number of factors.

This right to purchase the asset or exercise the option is virtually always limited to a predefined period. Sometimes it’s days, sometimes months, and sometimes years. The day when this right ceases to exist is called the option’s expiration day, or just expiration.

Once the time has passed, if the option’s holder did not exercise it, the option expires worthless. There do exist perpetual options — options without expirations — but that could be a whole different post, so we won’t discuss them here.

The above definition describes a particular type of option: the call option. With this option, you call on the owner of an asset to deliver it to you by paying the preset price. The choice to exercise is yours; your counterparty must comply.

There are other kinds of options. For example, the right to sell something in the future at a preset price, even if the price has later fallen, is called a put option. You are putting an asset into the hands of a hapless buyer. The buyer must buy the asset at the preset price, even if the asset is worthless.

Another term that subsumes options often used in organized financial markets is derivatives. An employee stock option is both a call option (see above) and an equity derivative security, which means that the option’s value is derived from its underlying stock price. Since the purchase price or the option’s strike price is fixed, the higher the stock price, the higher the value of the option.

This security to which an option is linked is called the option’s underlying security, or just underlying. In the case of an employee stock option, the option’s underlying is the company stock. The option enables you to get the more valuable asset, the company stock, for a fixed price.

Now that we have established some working terminology, what are the benefits of options, especially employee stock options? To answer that question and go beyond dry definitions and give you a feel for what options can do, we will return to Thales of Miletus.

Thales of Miletus reads the stars

How to use options

Aristotle writes:

“From his knowledge of astronomy [Thales] had observed while it was still winter that there was going to be a large crop of olives, so he raised a small sum of money and paid round deposits for the whole of the olive-presses in Miletus and Chios, which he hired at a low rent as nobody was running him up; and when the season arrived, there was a sudden demand for a number of presses at the same time, and by letting them out on what terms he liked he realized a large sum of money.”

The story contains several concepts pertinent to stock options, so let’s unpack them.

In the winter, Thales used a small sum to pay deposits for the right to rent olive presses during the harvest time. He basically made a reservation — so that when the time came, he had the right to use the presses. The full rent for the use of the presses would be due at the harvest, not in the winter when he paid the deposits. The rent was also low because there was no competition in the winter and because it wasn’t known how the olive crop would turn out.

If the crop were small, the presses’ weak demand would cause the rents to drop below the preset price that Thales had arranged with the press owners. In this case, Thales would not want to rent the presses. He would lose his deposit.

If the crop were large, however, the demand would drive the rents above his pre-arranged rent. Since Thales did not need the presses himself, he would charge the high rent rates to others and make a profit.

This is optionality. Constructively, it was a call option. Thales paid a small premium in the winter — the deposit — hoping that the price of the underlying — the rent — would rise above the strike — the preset low rent. This option’s maturity was probably around six months; if Thales did not rent the presses when olives were in season, the window of opportunity would close, and his options would expire.

The story tells us that Thales had to raise money to take this bet. He did not have enough and likely used all of it to reserve the presses. Had he rented the presses outright instead of reserving them, he would not have been able to secure as many because paying rent is more expensive than paying a deposit.

This is leverage — another important characteristic of options. You control a resource — the presses — with an amount of money — the deposit — much smaller than the full cost of the resource — the rent.

As it turned out, the stars told the truth. The olive crop was plentiful, and Thales made a large sum of money. In this case, the benefits of Thales’ olive press optioning are clear. Similarly, many modern forms of options, including employee stock, can be very valuable. The ability to pay a fixed price for the high-performing stock at a later date can lead to hefty payouts.

But an option is still a bet that is connected to a changing market. Since not all of us are prescient astronomers with insider information, what about the risks of options?

Thales actually played it very safe — he bought the options or went long the options, only risking the deposits he paid as the option premium. Though he had to fundraise the money, his overall risk was low compared to the possible rewards.

The olive presses’ owners were on the other side of his bet. They sold or wrote the call options to Thales. For them, it was also a fairly safe bet, because they owned the presses, and after collecting the deposits, the worst that could (and in fact did) happen was that they could not rent the presses at higher prices when the demand rose because Thales had exercised his options.

The press owners used a strategy that, in modern parlance, is called writing covered calls. (Remember our definition of a call above.) The calls they sold were covered because the presses’ owners, by having the presses, could at any time satisfy their obligation to Thales, that is, let him use the presses.

But many call sellers aren’t as prudent. One such example takes us to 17th-century London to show the real risks associated with options.

A London Exchange’s “corner”

Why options might be risky

In London, the organized options market emerged during the 1690s, and it immediately attracted naked (or uncovered) option selling. In this kind of deal, risk-takers would sell stock call options without previously owning the underlying stock. This is the other side of the coin from the positive example given by Thales: it explains where the dangers of options originate.

A call option writer who practices naked selling hopes that the option will expire without being exercised by the buyer. In which case, the seller gets to keep the premium collected from the buyer, which is essentially profit with no money down. However, things start going astray when the underlying stock price rises and the buyer exercises the option, forcing the option writer into selling a stock the seller does not have.

The risk in this situation is potentially unlimited—at this point, the seller must buy the stock in the open market for whatever the current price is, no matter how high, and sell it to the option buyer at the preset strike price.

In his circular “A Collection for the Improvement of Husbandry and Trade for Improvement”² published in 1694, Houghton describes the following scheme run by “the corner,” a group of London traders, to squeeze sellers of naked call options:

“But the great Mystery of all is, That some Rich Men will join together, and give money for REFUSE, or by Friendship, or some other way, strive to secure all the Shares in a Stock, and also give Guinea’s for Refuse of as many Shares more as Folk will sell, that have no Stock: and a great many such they are, that believe the Stock will not rise so high as the then Price, and Guinea’s receiv’d or they shall buy before it does rise, which they are mistaken in; and then such takers of Guinea’s for Refuse as have no Stock, must buy of the other that have so many Shares as they have taken Guinea’s for the Refuse of, at such Rates as they or their Friends will sell for; tho’ Ten or Twenty times the former Price.”

Let’s put this very 17th-century anecdote in the terms we just discussed. First, the “corner” would purchase as many stock call options (or, in their parlance, “refuses”) as they could. They assumed that many of the option sellers, hoping that the stock price would decline, would not actually have the underlying stock.

The corner would then buy as many shares of the underlying stock as they could in addition to the options they already held, thus running up the stock price. When the price rose, of course, they would exercise the options they held.

The poor options sellers would then scramble to buy the stock from the same people they needed to deliver the stock to — “tho’ [paying] Ten or Twenty times the former Price!”

This kind of racket may well have caused the historical reputation that options have — including employee stock options — as risky investments. In this case, the risk was taken entirely by option sellers, who were then taken advantage of by the clever and wealthy “corner,” behaviors like this can affect the stock market and options sales as a whole, causing instability and perhaps even crashes.

And while this is an extreme case, it’s always important to remember that the value of options is tied to the market, and thus, in constant flux.

But let’s leave 17th century London, go back to the 21st century, and turn to the options that are most likely to be relevant to you: options granted by companies to their employees.

Are we “In” or are we “Out”?

How to talk about your options

Now that you have a deeper understanding of what options are, let’s dive into employee stock options and how they stack up against the historical examples in terms of risk.

The good news for the holder of employee stock options is that while, historically, options have both risks and benefits, employee stock options are not as risky as you might think.

We’ll start with an example.

A two-year-old start-up hires you as a new employee and, as a condition of the hire, grants you 40,000 stock options. The preset purchase price (strike price) is set to the current share price, based on the most recent liquidity event, perhaps series A funding. Let’s say this is set at $1.

The options’ maturity is set to 10 years, the most common lifespan of an employee stock option. That means the options will expire in 10 years, and you can purchase the stock for $1 any time before the options expire.

It will be hard not to notice that I’ll be using different terms for the same things. That is because they come from two different fields. Terms like option spread, bargain element, and underwater defined later in this post come from court documents and IRS publications, whereas terms like intrinsic value, out of the money, and underlying are financial market vernacular. You will see practitioners preferring one or the other depending on their background.

Let’s look at a couple of scenarios. Suppose, a couple of years later, the company is doing well, and the stock is valued at $10 per share. Your options are in the money, meaning the stock price is higher than the strike price. The intrinsic value, or the bargain element, or the spread — these are many terms for the same thing—is $9. That’s $10, the stock’s value on the market, minus the $1 you will have to pay to get the stock.

You could exercise your options — that is, buy the stock — by paying $1, thus getting a $10 stock for $1. As you can imagine, this scenario could be quite lucrative.

In a different scenario, suppose things are not going well, and the stock had dropped to $0.50. Your options are out of the money or underwater, the intrinsic value is zero, and there is no sense in exercising the options. You’d be paying $1 for a $0.50 share of the stock, which is essentially losing money.

This doesn’t sound like a great deal for the employee who has 40,000 options to buy a $0.50 stock for $1. But remember, the market may change at any time. Company stock value may rise again before the expiration date.

Employee stock options are a considerably better bet than risks like naked selling; they are much more similar to Thales’ story than the story of the unfortunate sellers who got caught in the London “corner’s” scheme.

Like Thales, the holder of employee stock options has the right not to exercise their options if conditions are not favorable. The highest cost to the holder of employee stock options is the terms of the accepted compensation package and the opportunity cost of time spent elsewhere.

With all these factors in mind, it may seem difficult to figure how valuable your employee stock options might actually be. However, several key factors help determine the possible value of options, which we’ll discuss in the next section.

The two parts of an option’s value

What drives the value of an option

Here are just a few more key terms that will help you understand the value of your options.

When employee options are granted, they are usually struck at the money — the purchase price (strike price) is set to the stock’s current price. The option’s intrinsic value is zero, but the option is still valuable due to the underlying stock’s potential to rise in price.

That amount, the excess of the option’s value over its intrinsic value, is called the time value or extrinsic value of the option.

These two components – the spread and the time value—are the most important components to understanding how much value your employee stock options are likely to hold.

The option’s time value reflects the possibility that the option’s intrinsic value, or spread, will increase in the future. The more volatile the stock is, and the longer the option’s term, the more valuable the option is.

A long time to maturity and a volatile underlying stock make the option more valuable because of the possibility of the stock’s value rising while the option is alive. The stock could, of course, also go down, but remember, as the employee stock option holder, you are protected on the downside.

Parting thoughts

Options are powerful financial instruments that give you the ability to take targeted risks — but, as the traders in 17th-century London learned, they can be risky in some circumstances.

Employee stock options are among the many and varied types of derivatives. And while many factors affect the equation, your employee stock options give you the possibility to make money as your company grows without much of a downside.

Now that you have a deeper understanding of options as a whole, you’ll be better positioned to choose how you manage the risk of employee stock options.

We will be back shortly to continue this series on employee stock options and dive deeper into what you need to know to make informed choices. In the meantime, remember to take a look at your grant agreements, and don’t let your options expire!

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1. Aristotle. Politics, Book I, Part XI. (H. Rackham, Trans.). Perseus Digital Library. http://data.perseus.org/citations/urn:cts:greekLit:tlg0086.tlg035.perseus-eng1:1.1259a (Original work published 350 B.C.)
2. Houghton J., 1692-1703, A Collection for Improvement of Husbandry and Trade, London, Taylor, Hindmarsh, Clavell, Rogers and Brown (reprinted: 1969, Farnborough, Gregg International Publishers).