When you work at a company for a while, some companies give you “stock options” at a nice discount. I used to think that meant that you get to buy the stocks for a cheap price. But that's not what it is. When you get stock options, the company is giving you these things called options for the company's stocks. Options are just like stocks you can buy and sell, except it's a contract that allows you to buy something at a fixed price in the future.
So, for example, let's say that your company's stock is worth $2 today. Your company may feel generous and give you a free option that lets you buy 100 shares of the company's stock at $1 10 years from now. 10 years from now, you'll be able to buy 100 shares of the company's stock at a dollar, at which time you can buy the stocks and sell them at some point to make a ton of profit if your company has been doing well. Alternatively, you can sell the option to someone else who is willing to pay you for them — that way you don't even need to buy or sell the stocks yourself. The third option is that, if the company's stock has fallen below $1, then you can throw away the option which no longer has any value.
The most common form of options is stock options — options that lets you buy stocks — but there can be other forms of options. Some people buy gold options, for example, if they want the rights to buy the gold at some point in the future and if there's someone willing to sell such option to you. Stocks, golds, etc. are called the underlying security of the option, and are bought/sold in standard unit of increment. For example, one stock option for MSFT will allow you to buy 1 lot of MSFT (100 shares) in the future.
Also, even though your company may give you stock options for free, you can also buy them — usually at a cheaply discount rate of dimes to a dollar. Remember, however, that you're only paying for the rights to buy the stocks (or gold or copper or whatever the underlying security) at a specified price in some specified future date, you're not buying the stocks at this discounted rate. So you don't make any money unless the stock's actual price ends up going higher than the price you paid to purchase the option plus the price you agreed to pay if you chose to exercise the option. On the upside, in the worst case scenario the stocks lose their complete value, you only lose the amount of money you paid for the rights to purchase the stocks, not the entire value of the stocks. This makes options an attractive alternative to stocks for those interested in pure capital gains investment with no interest in dividends or voting rights that come with owning a stock.
Options can be confusing because it has two sides,1 two prices, and one date:
- You can buy an option or sell an option right now. When you buy or sell the option right now, it will be traded at a specific price. That's one side and one price, both relating to how the option is to be traded right now.
- The option itself will allow you to buy the underlying security in the future, or allow you to sell the underlying security in the future. Do not get this confused with whether you are buying the option or selling it — You can, for example, buy an option that allows you to sell 100 MSFT one year from today; conversely, you can sell an option that allows them to buy 100 MSFT one year from today. An option that allows you to buy the underlying security in the future is called the call option. An option that allows you to sell the underlying security in the future is called the put option.
- Correspondingly, there is also a price at which the underlying security will be traded in the future. For example, you can buy an option that allows you to buy 100 MSFT at $30 in the future. You can also buy an option that allows you to sell 100 MSFT at $30 in the future. But the option itself may cost $1 to buy. This “future price” is called the strike price of the option.
- Furthermore, the option may allow you to buy/sell the underlying security one day from today, one week from today, one month from today, etc. The date at which the option can be exercised is called the exercise date.
Similar to options are futures. Futures are like options in that you purchase something for the future, except you pay for the goods up front. There are no fees for the “rights” — you just pay for it now at some agreed price, and you get the goods later. I suppose futures aren't really useful for stocks (it's same thing as buying the stocks now and holding onto it until the exercise date) but you could buy the future for oil, guaranteeing that you'll have a fixed price on the oil at some time in the future. Airline industry would buy the oil future to fix their oil price, for example, to prevent the airline spending costs from skyrocketing due to some unforeseen middle-east conflict.
The crazy thing is you even buy the future for things like the weather. When you buy the “snowy weather on December 1, 2008” future, you're purchasing the weather future from the seller of such future. If the seller cannot deliver the future, the seller will compensate you (pay you) for breaking the contract. This is a form of insurance that, for example, a ski resort could purchase to minimize their business hit in case the snow season does not start at the desired date. The seller could be a farmer that needs a sunny weather for his farm that would be willing to pay someone for a good weather but needs to be compensated for crop damages if the snow falls on that day.
So now you know how to protect your business if you have your own a company or what to do if you work for a nice company that gives you stock options.
Futures are traded the most in the U.S. at the New York Mercantile Exchange (NYMEX.)
