How stock options work
Put and Call Options
A stock option is a contract creating a right to buy (call) or sell (put) a share of stock.
A call option is the right to buy one share of stock of company X at a price Y (called the "exercise price," or "strike price"). In standard American stock options, the seller of the option promises to sell one share of stock at the strike price - at any time during the term of the option, typically from issuance until a specified final date (the "termination date"). It is an option because the holder has the right - but not the obligation - to buy the stock.
A put option is the same thing in reverse: the issuer promises to buy the stock at the strike price on demand during the option period.
Option holders make money by exercising call options when the market price is higher than the option strike price. They buy the stock from the option issuer at the strike price, sell the stock on the market for the higher market price, and pocket the difference as their profit. They make money on put options by exercising when the market price is lower than the strike price - they buy the stock at the market price, sell it to the issuer at the strike price, and pocket the difference as their profit.
When an option holder can do exercise the option and make money, the option is called "in the money". Note that a call option is "in the money" when the exercise price is below the market price, and a put option is "in the money" when the exercise price is above the market - but in both cases the holder has won the bet.
The seller loses an equal and opposite amount: it must buy a share to sell to the call option holder, or sell the share it receives from the put option holder, and it will lose an amount equal to the holders winnings: the difference between the strike price and the market price.
If the market price is the same or lower than the strike price, call option holders simply let the option expire. Similarly for put options: if the market price is the same or higher than the strike price, the option holder won't make money by exercising it, and therefore doesn't. Options where the option holder would not make money by exercising it at the current moment are called "out of the money." If the option expires out of the money, the issuer has not lost anything.
Note that the terms are not symmetrical. If the option is in the money, the buyer wins; if the option is out of the money, the seller doesn't lose. So why do sellers sell? How do they expect to make money? They charge for the option right up front. This charge is called a "premium."
Thus, options are quite similar to insurance. The issuer is the insurance company, insuring against future price declines in the stock price (below the strike price). The fee is the premium for the insurance contract. The issuer makes money by charging enough in premiums to cover the eventual payouts on contracts where the stock price declines and it has to pay out (and by investing the premium between the time when it issues the contract and when it has to pay out on some of them). Insurance companies (such as AIG) thus sometimes get into the business of issuing options because they are experts in predicting the likelihood of payoffs, and/or in investing premiums prior to payoff.
Options are also quite similar to margin loans - i.e., secured, non-recourse, loans to buy stock. The payoff for a call option holder is essentially identical to the payoff for a stock buyer that borrows an amount equal to the strike price and uses it to buy a share.
Consider what happens if a buyer buys stock using borrowed money. If the stock goes up, the borrower pays off the loan and pockets the difference between the loan amount and the market price - just as a call option holder pockets the difference between the strike price and the market price. If the stock goes down, the borrower defaults. The borrower has made nothing, but is out nothing - just like a call option holder that allows the option to expire unexercised.
On the other side, the margin loans looks more like a put option. From the bank's perspective, it makes money on a margin loan by charging interest and hoping that the stock price goes up (in which case the borrower will repay the loan). This is like selling a put option: if the stock price goes up, the borrower will have paid for the option and will let the option expire unexercised. On the other hand, if the stock price goes down, the bank receives back the stock, and loses the difference between the strike price and the market price - just as if it had sold a put option. Note that if a bank buys an equal and opposite put option, it can protect itself against the risk of market movements and be in the business it usually wants to be in: lending money and assessing credit risk (not stock market price movements).
Banks and investors, thus, often see the sale of options as quite similar to loans, with the premium representing interest for use of the bank's money and the risk of non-payment.
Pricing options is quite difficult. At the moment before they expire, the value is clear: if the option is in the money, the value is the difference between the strike price and the market price. If the option is out of the money, the value is zero. But at any time before that, there is also the value of the bet that at some point in the future the stock price will move so that the option will have more value than it would if exercised now. That extra value is called the 'option value'. Putting a number on it is not easy; the common formula is known as "Black-Scholes" after its inventors (who won a Nobel memorial prize in Finance for it). Black-Scholes basically separates the option into a margin loan (with an interest rate heavily dependent on market interest rates) plus a bet on future volatility (with odds calculated by examining past volatility), assuming that an option is worth more the more the underlying stock bounces around in price, since the more bounces the more likely a high one.
Employee stock options
Companies often issue call options on their own stock, often as a form of payment for executives or other employees.
The option recipient receives the right to purchase one share of stock at a specified price at any time during a specified period. The company - the issuer - is required to sell the stock to the employee at the strike price; it can either sell treasury stock or authorized but unissued stock, or it can buy stock in the market to sell to the option holder.
Employee stock options usually differ from standard call options in two respects. First, often the time period for exercise does not start immediately: for example, an executive might receive 10,000 options vesting in one year with a term of ten years. That means that the executive would have the right to exercise the option at any time during the nine years between one and 10 years after issuance. The purpose of this is to ensure that the employee has an interest in making sure that the stock price goes up and stays up - the higher the stock price the more money the employee will make, but if the stock price doesn't go up, the employee doesn't make any money. Second, in order to help enforce the first rule, employee stock options usually aren't transferable (otherwise the employee might cash out by selling the option instead of waiting to see if the stock actually goes up).
Under American income tax rules, if the strike price is equal to the market price at the time of issuance, the recipient has no taxable income. The logic behind this is that if the recipient were to exercise the option, he or she would not make any money, and the option is not transferable. So at the moment of issuance, there is no way for the employee to generate cash. Even though the employee has received value - he or she is richer - the gain is unrealized. When the employee exercises the option, the difference between the strike price and the market price - the employee's profit on the option - is treated as ordinary income (i.e., as salary rather than profit). The option value - that is, the value of having the right but not the obligation to exercise the option - is never taxed at all.
Because of this income tax treatment (and until recently because of even more lenient accounting rules), employee stock options almost always have a strike price equal to the market price at the date of issuance.
Executives paid in options have extremely asymmetrical economic interests. If the stock price goes up, they make money and if it goes up a lot they make a lot of money. But if it stays flat, goes down a little, or collapses all the way to zero or beyond - they simply allow their options to expire unexercised. This "heads I win, tails I don't lose" payoff may provide an incentive for extreme risk taking: a strategy that has a 90% chance of destroying the company and a 10% chance of making the stock price double will be far more economically lucrative to an option holder than a steady-as-you-go course that maintains the status quo, preserves jobs, product, interest payments and dividends, but at the expense of little stock price movement.
Notice also that when a company issues a dividend, the stock price often drops by an amount equal to the dividend. This suggests, conversely, that if the company does not issue a dividend, its stock price should go up by an amount reflecting the money that stays in the company. Option holders, of course, see the value of their option go up when the stock goes up - but do not themselves receive dividends. Thus, stock-option holding executives have a strong incentive to not issue dividends.
-- Daniel JH Greenwood (2009)