Stock Options 101
Are you looking at a promotion at work that involves stock options as part of the comp package? Or maybe you’re a retail trader being drawn in by the allure of trading a levered asset class? Perhaps you’re just wondering what these things are. Either way, we’ve got you covered. Options are one of our specialties. So what is a stock option?
So what IS a stock option?
A stock option gives you (the holder) the right to buy stock in the company at a certain price before some date in the future.
If the stock price appreciates above the exercise price of the option, then you, the holder, can exercise your option to buy shares and turn around and sell them into the market for a profit.
When an employer issues stock options (Employee Stock Options, or ESOs), the agreement will contain vesting terms and other stipulations. However, in the public options market, all contracts are standardized to the same set of terms.
Why are they so important?
Stock options are a very important piece of the compensation package for many employees, because they allow for that employee to be compensated for the growth of the business.
Secondly, they allow the company to align management interests with investor interest by awarding de facto bonuses on stock price appreciation.
And lastly, this "bonus" doesn't cost the employer a dime if the employee doesn't perform.
Stock Options Example
You work for Chevron Stationery Co. As part of the compensation package, your company issued stock options to buy 10,000 shares of the company at $50.00 per share. The stock of the company is currently trading at $40.00 per share.
Outcome 1: Stock goes to $55.00
The performance of your team is outstanding, and as a result, the stock price soars to $55.00 per share. You exercise your options and buy 100,000 shares at $50.00 per share and immediately sell them at $55.00 per share, realizing a $500,000 profit.
Outcome 2: Stock drops to $35.00
The performance of your team is poor, and as a result, the stock price falls to $35.00 per share. Your options expire worthless.
Do Stock Options create any problems?
We answered the question, “what is a stock option?” and you learned why they are important. Are there any potential problems using stock options as compensation for performance?
Yes. And it’s a big one. It almost single-handedly created a massive, massive asset bubble.
At its core, here is the problem: because stock options tie directly to share price, the incentive is tied to the share price, not the productivity of the company.
Share price can be manipulated, whereas productivity cannot.
Since executives are directly incentivized to boost share price by whatever means necessary to create worth in their options, many of those executives artificially elevate the share price by adding debt to finance buybacks, without adding to the productivity of the business.
If the share price is higher, the investors are happy, but if compensation (via options) incentivize the option holders to play a shell game with the balance sheet, long-term investors are going to pay the price.
Company debt itself should be an investment with an expected return to revenue. Adding debt to decrease the share count does nothing for a company’s revenue. It increases earnings per share (less shares + same earnings = increased EPS), but doesn’t actually grow the business. Ultimately, this hurts long-term investors and the company itself.
We belive that stock options as a compensation form do not properly align long-term investors and the executives driving the company. Others disagree.
Common Q&A:
I get it, but what IS a stock option? Is it a piece of paper or actual shares of stock?
It’s neither. A stock option is a fictitious obligation for the company and privilege to the holder. The option is a “derivative” of the stock price. It exists in the ether until it vests and becomes shares.
Can I buy my own stock options?
Yes, options trade on many public companies, and are available to buy and sell with all the protections of the appropriate industries. There is a well-developed community of options traders, and entire hedge funds that do nothing but trade options.
What can I do with options?
Options exist for two purposes: speculation and hedging. You can use an option to bet on a price rise or price drop of a company, or you can also insure your existing positions or new stock positions against losses.
I have stock options in my company. What now?
You’ll likely have to wait until vested or until certain milestones are hit before you can do much, however, there are many things you can do even before you are fully vested. You can bring in additional capital against your existing options. You might consider hedging against share price declines in the open market.. The possibilities are endless when it comes to options. The only limit to what you can actually do with an open options position is your imagination. And probabilities. Always probabilities.
Don’t want to do that? We can help. One of our specialties is working with options. We have taught and continue to teach many traders to use them successfully, and have sub-advised and consulted with options-only hedge funds. Get in touch to see how we might be able to help you.
I have restricted stock. Can options help?
Yes, you can actually buy and sell options to hedge your RSUs, assuming a full vesting. Contact us for more information and a free consultation on how we can help protect your RSUs from a stock decline.
We hope this article was helpful in answering the question: what is a stock option? If you have questions or comments, feel free to post in the comments below.