What are Stock Options?

Broadly speaking stock options can take on two forms - options that you trade electronically on a public options exchange and stock options that are granted by a company, which you can exercise in return for shares in that company. This article will explore the later, which are also referred to as Employee Options. Tradeable options (calls and puts) are generally referred to as Equity Options. Both stock and equity options are a financial asset known as a derivative.

Companies issue stock options (called Share Options in the UK) to their employees, which give the employee the right - but not the obligation - to buy a certain amount of shares in the underlying company at an agreed price at an agreed date in the future.

The agreed price is called the exercise or strike price and the agreed date is the expiration date.

How is the exercise price calculated?

The directors of the company decide on an exercise price, which is usually set higher than the current traded share price of the stock. As stock options are almost always European style (can only be exercised at the expiration date) the idea behind the high strike price is to encourage employees to work harder so the share price performs to reflect this.

Another method companies use to determine the strike price is to base it on the average price of the stock over a given period. For example, a company may grant an employee stock options that expire in 6 months and strike the options at the average price of the stock over that 6 month period.

Non-Qualified Vs Incentive Stock Options

If you're employed by a US company you may have come across these terms before. They are a sub-classification of employee stock options (ESO) and related specifically to the amount of tax holders of employee stock options are required to pay.

Non Qualified Stock Options

Non Qualified Stock Options (NSO) are the simplest type of stock options where the employee is required to pay ordinary income tax on the profit. The Internal Revenue Code classifies options as NSO's when there specifications do not meet the requirements of an Incentive Stock Option (ISO).

When an employee exercises an NSO s/he will be required to pay tax on the income earned, which will be the different between the price of the stock at the time exercised and the strike price of the option. What employees might not realise is that many employers choose to issue NSO's because as the issuer of the option, the employer can offset the income the employee earns as a tax deduction on company income.

Incentive Stock Option

The other classification of an employee stock option is an incentive stock option (ISO) - not sure why they're called incentive and not qualified, but they are often also referred to as qualified.

In order for stock options to be classified as ISO's they must meet two criteria;

1) The shares exercised by the holder of the options must be held for more than one year from the date of exercise.

2) The shares exercised by the holder of the options must be held for more than two years from the date that the options were granted.

Incentive stock options that are exercised means that any gains are then classified as long term capital gains and taxed accordingly, rather than taxed as ordinary income tax.(in the U.S a long term capital gain is taxed at a lower rate).

Employers who issue ISO's cannot use the gains as a tax deduction like they can with NSO's.

The burden on the employee, however, is that s/he must hold onto the stock for a longer period of time in order to take advantage of the special tax treatment, which means additional risk for the employee.

How to value Stock Options

So you've been granted some options on your company and you'd like to know how much the options are worth?

Option valuation can be broken down into two components; intrinsic value and extrinsic value.

Intrinsic value is the price of the option that you would realize if you exercised the option now. The intrinsic value will be calculated as the maximum of zero and current market price of the stock minus the strike price i.e.;

max(0, Stock - Strike)

For example, say you've been granted employee options with a strike price of $25 and your companies shares are currently trading at $30. The intrinsic value of the options is $5. That doesn't mean the options are worth $5 each though as you have the other component of the option price - the extrinsic value.

The extrinsic value of an option is also called time value. As the option has an expiration date attached to it, there is value in that the stock may be trading higher than the current value and therefore be worth more in the future than its current intrinsic value. For example, if you are holding a $25 call option that expires in one year and the stock is currently trading at $30, then there's a good chance that the stock is going to be trading much higher than $30 after a year. Because the contract is an "option", you can elect not to exercise your option if the stock is below the strike price - meaning that there is only upside potential. So the additional time you have for the option to trade higher is valuable to the holder of the option.

This all comes down to the volatility of the underlying asset. Volatility is a measure of an asset's price fluctuations and the more volatile a security is the more chances there are that the security will be trading above the strike price in the future.

To estimate a stock's historical volatility you can download my Excel based Stock Volatility Calculator. This tool will grab historical price data from Yahoo given your time parameters and calculate the historical volatility for any timeframe that you choose.

Now that you have the volatility you can use an option calculator to determine the stock option's theoretical price. Here are some examples;

Option Trading Workbook - An Excel based option pricing tool
Online Option Calculator - A web based option pricing calculator

NB: at the time of writing both of these tools use the Black Scholes method to calculate the option price as company stock options are generally European. Equity options traded electronically are most often priced using a binomial tree pricing model as these options can be exercised prior to the expiration date. Both models are commonly used in the markets to price options.

Stock Option Exercise

Ok, so you now have the tools to calculate the theoretical price of a call option, but would you bother? Unlikely. All you would really care about is if the options are in-the-money and if you can exercise them and collect your money.

Once the expiration date passes and the stock price is above the strike price you would just go ahead and exercise the options. This can happen in two ways.

Take Delivery of the Stock

Once you tell your company that you'd like to exercise the stock you may be required to take delivery of (actually buy) the underlying stock. If this is the exercising procedure then make sure you have enough cash to make the purchase.

After you receive the shares in your account you can simply go in the open share market and sell them via a stock broker to realize the profit.

Cashless Solution

If you don't have the spare cash available to take delivery of the asset you might want to check with your employer if they provide a cashless solution for stock option exercise.

Many companies will do this for their employees. They will operate in conjunction with a bank/broker by taking delivery and selling the shares on your behalf and simply providing the profit proceeds to you in your account or via company cheque.

This is the most common outcome for employees who exercise in-the-money stock options - except in cases where the employee prefers to retain ownership of the shares for future growth.

How do Stock Options Differ to Equity Options?

Here are a few key differences between company issued stock options and exchange traded options (equity options);

  • Stock options are issued with long expiry dates i.e. a year or two to expiration while equity options can be listed by exchanges with expiry dates every month
  • Stock options are only calls, which the employee buys (or goes long the call). With equity options a trader can buy and sell both call and put options
  • Stock options are granted with a ratio of 1 option to 1 share, while equity options carry a multiplier, which can range from 100 (US ETO's) to 1,000 (Australian ETO's)
  • As stock options are long only there is never a requirement for margins whereas equity options can require margins for short positions
  • Equity options require the premium to be paid upfront at the time of the transaction while stock options are "granted" to the employee
  • Stock options are almost always European while most ETO's are American in their exercise style

Further Reading

What Determines Early Exercise of Employee Stock Options

SEC - Employee Stock Option Plans

Employee Stock Purchase Plan

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