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Question:


How do stock options work?
-ShallowVal


Answer:


Options are securities that convey the right, but not the obligation, to buy a fixed amount of an asset, such as shares of stock, at a specific price, at or before a set time, say 100 shares of Apple at $400 a share by the third Friday of October. There are two broad kinds of options. One is traded on a stock exchange and anyone with adequate resources can buy or sell them. Only sophisticated investors with healthy bankrolls should buy options because their value can change drastically, quickly. Apple recently traded for about $420 a share. That would give the option contract in the example above an intrinsic value of $2,000 ($420 - $400, times 100 shares). If Apple drops below $400 by mid-October, the option expires worthless, and if Apple rises to $500, it would be worth $10,000.

The potential for the option to increase significantly in value, while it can never be worth less than nothing, means that the buyer usually must pay a premium. The Apple option might cost $50 a share, say, if the intrinsic value were $20 and four months remained until expiration. And who would be selling such an option? It’s likely to be an Apple shareholder who wants to cushion the impact of a decline in the stock by pocketing the premium. If Apple were to fall from $420 to $350, that’s too bad, but at least the loss to the shareholder would be reduced by the amount netted from selling the option.

The second kind of option is awarded as part of an employee’s compensation instead of being bought and sold. It typically has an exercise price, the price at which the shares can be bought, that is a lot lower than the stock’s market price. Sticking with Apple, an employee for the technology company might receive an option to buy 100 shares at $200 each. With the stock trading at $420 a share, that option would have an intrinsic value of $22,000 ($420 – $200, times 100 shares). Why wouldn’t the company just write the employee a check for $22,000? Tax reasons, possibly. Also, because employees often must wait several months or longer to exercise this kind of option, it aligns the long-term fortunes of the employee and the company more closely.

-Conrad de Aenlle



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