How Do Stock Options Work?

Want a simple explanation of how stock options work? Well hopefully this article will explain them as simply as possible while still providing with the appropriate terms that will have you sounding like you’re in the know.

What are stock options?

Stock options are interesting tools for compensating employees by allowing them to buy stock in the company at some future date at a currently agreed upon price (usually the current stock price.) A very simple example of a stock option is shown below.

Employee John joins the company on 1/1/2014 when the stock price is $70 per share. The company grants John stock options for 100 shares “callable” in two years at the current $70 per share price (this $70 could be any amount, but using the current stock price is common.) In two years, 1/1/2016, let’s say the stock price has risen to $120 per share. In this case, John would likely “exercise” his options by buying his 100 shares for $70. If John were then to sell these stocks back to the market (say through his personal broker) he has effectively netted ($120-$70)*100 = $500 minus any transaction fees. If over the course of the two years, however, the stock price dropped to $50 (or anything less than or equal to $70 for that matter, would effectively make the options worthless. John would let his options expire, or await a future date when the stock rises above $70.

Stock options are used as compensation by companies for a variety of reasons. One major reason is that companies feel that options incentivize leaders to act in ways that will increase stock prices. Without an increase in stock price during the vesting period, the option is effectively valueless. To avoid this fate leaders will strive to act in an effort to increase stock prices. There are a number of additional reasons why stock options are used as compensation methods, and conversely a variety of detractors to the use of options. This article, however, is meant as a quick crash course on the fundamentals of how employee stock options work.

Fixed Cost – Along with variable cost, it is one of the two components of total cost of production. The fixed cost is a cost that does not vary based on production levels. For example, the cost of rent, machinery, and administrative overhead does not increase or decrease based on the amount of production. These costs are the same, or fixed, regardless of production levels.

Variable Cost – Along with fixed cost, it is one of the two components of total cost of production. The variable cost is the costs that vary (increase) based on the number of units produced. For example, raw material and labor would be considered variable costs. For each unit produced, it will require more labor and more raw materials. This is in contrast to fixed costs that don’t change based on production such as rent, administrative overhead, machinery, etc.

Adam Smith – 18^th century that coined the term and concept of the “Invisible Hand.” The Invisible Hand is the philosophy that if left unadulterated all marketplaces would reach a point of equilibrium – where the price of a given product and the quantity created would equal the point at which the supply and demand curves cross.

Hayak – A very simplified version of his philosophy is that in times of recession/depression, the best way for the country to recover is for the government to administer fiscal restraint, and allow for certain struggling businesses to fail to cull the poor performers and allow for the strong companies to thrive in the long term.

Keyne’s – A very simplified version of his philosophy is that in times of recession/depression, the best way for a country to recover is for the government of that country to begin spending exorbitantly to reinvigorate the economy and protect struggling businesses.

Economies of scope – A concept similar to economies of scale, except it deals less with product unit cost, and more with the overall benefits to a firm by producing more of a given product or mix of products. Examples of Economies of Scope include: 1) a company that delivers packages to homes could more cheaply add letter delivery to their service offering than a company performing a less related service 2.) An ice cream company could manufacture another flavor for an overall reduction in production costs. This is because it is supposed that they would create the ice cream on the same machinery (decreasing fixed cost per production volume) and they could perhaps get volume discounts from their suppliers for cream and sugar since these raw materials would be required regardless of the new flavor chosen.

Economies of scale – A cost advantage that is recognized by the increased production of a given product. This concept basically describes the situation where a company can produce a product more cheaply when they produce more of the product. This concept is most easily understood when considering a company with high fixed costs. For example: A company manufactures a product with raw materials costing $1 per unit on a machine that costs $100. If the company produces and sells 100 units, their total cost per unit was $2, or $1 of raw material and $1 of fixed costs ($100 machine/100 units = $1). If that same company was able to produce and sell 1000 units, their total cost per unit was $1.10, or $1 of raw material and $0.10 of fixed costs $100 machine/1000 units = $0.10). The company is increasing their economies of scale by increasing their production output.

Oligopoly – A marketplace environment dominated and controlled by a small number of sellers. Think of this as a monopoly involving more than two companies.