
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.