Stock Option Basics

Stock options were originally conceived as a tool for startups who couldn’t afford to pay new employees as much cash as their established competition. While some still view options as Silicon Valley give-aways for overpaid young executives, they have blossomed in popularity and have become regular additions to compensation packages in most publicly traded companies. Whether you are entering into negotiations for a new job or you have just been given stock options as a bonus, it is important to understand the basics so you know how much value you are actually receiving from your company.

The stock option is probably the most logically named financial instrument. A stock option is simply the right to buy stock in a company at a specific price called the strike price. The strike price is usually the price that the company is trading at when you start work at the firm. The strike price remains fixed no matter what happens to the price of the stock in the marketplace. There are also time restrictions on when you can exercise your options. It is usually a three or four year period where a certain number of shares become available for you to purchase after each year. This is called the vesting process. If the vesting period is four years, each year one quarter of your options become vested and you can cash them in at that time. After four years, you are fully vested. If you leave the firm before you are fully vested, you forfeit all options that are not vested. The value of your stock options is based on the number of shares you receive, the value of the strike price, and the length of the vesting period.

Let’s look at an example. Let’s say you are hired by ABC Corporation. You negotiate your salary, health benefits, 401(k), and you are offered 2,000 options at a strike price of $25. That means that whatever happens to the price of the stock, you can purchase up to 2000 shares of ABC Corporation at $25. So, if the price of ABC flies up to $125 after you are fully vested, you can buy 2000 shares at $25 and immediately sell them on the open market for $125. Your options are said to be “in the money,” worth $200,000. If the stock falls below $25, you certainly would not exercise your option to buy them at $25. You would immediately lose money. Your options are “out of the money,” worthless for the time being. If your options expire without the stock price reaching the strike price, or the company goes bankrupt, you finish out of the money.

Remember that like any equity investment, you are at the whim of the market and there is no sure thing. You may like stock options because they could be worth millions in a matter of years and because you benefit from any rise in the stock price from the minute you start working. But remember also that your company likes stock options because they tie your performance to your compensation.  Also, options allow them to forego paying huge salaries by offering future rewards that won’t mature until they have grown. If the company goes bankrupt, your options are worthless and you are also out of a job.

It is important to not rely on stock options as a sure thing. If you have the power to negotiate your salary and your options, take into account your risk barometer. If you are risk averse, try and negotiate a higher salary with fewer options. If you are a risk taker and you believe strongly in where your company is going, try and attach as many options to your compensation package as possible.

Here is a quick glossary of option terms:

Vesting Period: Vested simply means available to cash in. The vesting period is the schedule by which your options mature. If the vesting period is four years, one fourth of your options mature each year and you are fully vested after four years.

Strike Price: The strike price is the price at which you have the option of purchasing the stated number of shares in your company. The strike price is fixed and does not change relative to the market price.

In the Money: If the price of the stock in the marketplace is higher than the strike price, your options are “in the money.” The difference between the market price and the strike price is the amount you will profit on each option.

Out of the Money: If the price of the stock in the marketplace is lower than the strike price, your options are “out of the money.” They are worthless because you could buy the same amount of shares on the open market for less than your set strike price.