stock options


What are stock options? I’ve been hearing about puts and calls on the financial networks for years but never understood them. How does the average person get started?

In: 5

An option is a type of contract where you have option to buy (call) or sell (put) at a specific price at a later time.

A call can limit your downside risk vs just buying the stock. You buy the call at a price near where the stock is currently trading. If the stock later goes up, you exercise the option, then immediately sell at the higher price and pocket the difference. If the price goes down, you don’t exercise and you’re only out the price of the call option you bought. If you had bought the stock you could potentially lose your entire investment if the company goes bankrupt or something.

A put can be used for short selling, again, limiting the downside risk to just the cost of the option. If you do just a basic short sale (not a put) and the price skyrockets like a meme stock, you could be on the hook for a lot of money!

If you want to get started, ah, open a brokerage account.

Let’s say you work for me. No matter how I choose to pay you for that work, the tax authority (let’s say the IRS in the US) wants you to pay taxes on it. It doesn’t matter if I pay you in cash, gold bars, trips to Fiji, or real estate. That is income, and the tax man wants his cut.

This is a bit of a problem for startup companies. They don’t have lots of cash to pay people. Instead, they want to pay people by giving them stock in the company. That way, if the company is super successful, they’ll be millionaires later.

But as a startup CEO, if I just give you stock outright, you owe taxes on it now. That stock might not be worth millions yet, but it’s still worth something. Trouble is, 95% of startups fail, meaning you’d have paid taxes on something that might end up being worth nothing later.

That’s not a great bet for you. So companies started to do something clever. Rather than giving you stock outright, they set it aside, but with your name on it. And instead, they give you a contract that says you *have the option to buy the stock* from them at a later date.

Usually, the contract says you have the right to buy the stock at its *current* low price. Say, $0.02. (Called the “strike price.”) *No matter what the price* of the stock is at that future time (say, $300), you can buy that stock from them for $0.02, then immediately sell it for $300.

Of course, you now owe tax on the $299.98 profit you just made. But you assumed none of the risk of paying taxes up front and then having the company go out of business. So this has widely become the normal way to give employees stock in a company before it goes public.

Now, say the company is wildly successful in only a year. Companies don’t want all of their employees exercising their contracts and retiring rich immediately, leaving the company with no one working. So options usually have what’s called *a vesting schedule.*

Under this arrangement, only part of the stock *vests* (allows you to buy it if you wish) in stages, depending how long you’ve been at the company. For early-stage tech companies, it’s become typical for full vesting to take 4 years.

It might vest in chunks every month, or once or twice a year, or whatever schedule the company says. But if you leave the company before then, you lose the rights to whatever part of that stock remains unvested.