How do Stock Options Work?

Stock option plans have been around forever.  This makes it all the more baffling that so many people simply don’t seem to understand how it works.  This is forgivable for individuals who aren’t employed by companies who provide stock option plans, but various surveys have indicated that the majority of people who own stock options still don’t understand them!  Don’t be one of those people.

The easiest way to understand a stock option grant is that you aren’t actually being granted any stock.  You are being granted the right to buy stock at a specific price.  This price is often referred to as the strike, grant, or exercise price.  We’ll work with nice easy numbers to illustrate this concept.

Scenario One

You are granted 1000 shares of company stock at a strike price of $10.  The vesting period is 3 years.  The vesting period is the minimum amount of time you must wait before exercising the option.  Three years later, the company stock rises to a value of $20.  In this case, you still own nothing until you exercise your option.  However, you now have the right to purchase 1000 shares at $10, when they are valued at $20 on the open market.  In other words, you can buy $20,000 worth of shares for only $10,000.  In other words, you stand to gain an easy $10,000 in profit!

 

Scenario Two

You are granted 1000 shares of company stock at a strike price of $10.  The vesting period is 3 years.  Three years later, the company stock falls to a value of $5.  You still own nothing until you exercise your option.  You’ll notice that the current price is actually lower than the strike price.  Let’s say you’re a complete imbecile and choose to exercise this option anyway.  You’d essentially be purchasing $5000 worth of stock at the price of $10,000!  An immediate $5000 loss.  Doesn’t make much sense does it.  In actuality, this situation is often impossible because many systems don’t even allow you to exercise the option if it’s below the strike price.  The option will simply expire and become worthless.

So Why Do Companies Do This?

The idea of a stock option is not just to give you free incentive money.  That’s a goal that a straight cash bonus fulfills.  The concept of a stock option is that it is an incentive plan that better aligns the employee’s goals with the employer (theoretically anyway).  The employer wants the stock price to go up because obviously that will increase the market capitalization and overall value of the company.  The employee wants the stock price to go up, because the value of their stock options will rise accordingly.  So theoretically, the employee will work harder because their own financial interests are directly in line with the company’s.  In practice, this doesn’t always work because publicly traded companies have so many employees that the contributions of a single individual will mostly likely have a negligible effect on the overall stock price.  But that’s the idea, and it’s a pretty straightforward one.

Conclusion

So hopefully you now have a complete understanding of what stock options are and how they work.  If you don’t, please leave any outstanding questions in the comments below.

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