Accountancy Resources
Options in general are investment tools that give the holder the right, but not the obligation, to buy or sell shares. There are often time limits on these options and after the expiry date, the right to buy or sell shares will expire.
Call options represent the right to buy a set number of shares at a certain price (called the strike price) until the expiration of the option.
When purchasing a call option at a certain price you are in essence investing in the belief that the share price will be greater than the strike price of the option when you exercise it.
You’re also expecting that the price difference will be sufficient to cover the actual cost of the option when you paid for it.
Call options are not always paid for, as many companies have stock incentive plans that involve free options being awarded for performance or years worked. While these are referred to as stock option plans they are specifically call option plans. In this case, the option strike price is often a discount from the current and expected stock price, so that when employees redeem the options they will already have value. In the case of employee call options, they are often awarded but then take some period of time to ‘vest’ before they are eligible to actually be used.
As with any transaction, there is a seller when a call option is purchased. The seller of the option is agreeing to sell a share for the strike price in the option at any point before the option actually expires. So if the share is worth more than the strike price they will either sell the share they have (essentially at a loss) or have to buy a share and then sell it at the lower price indicated in the option. The price paid to buy the option is what the seller values their risk of losing money at.
Put options represent the right to sell a set number of shares at a certain prices (also called the strike price) until the expiration of the option.
In this case, the buyer of the option is investing in the belief that the share price will be less than the strike price of the option when they exercise it. If the price is lower they can then buy the share and sell it at a profit immediately. Put options will not be seen in employee incentive plans, as no company is going to build a compensation structure that is built on a company’s stock value going down.
In a put option sale the seller of the option is agreeing to buy a share at the strike price, and the cost they charge for the option is based on the risk that they will actually have to lose money on the put option. In some markets, there has been resistance to allowing put options on markets as they have been criticized for putting downward pressure on stock markets. As countries are seeking to boost their economies and stock markets they are heavily critical of allowing negative bets against them.
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