Share options

What Is Share Options?

Share options are a type of derivatives contract that grants the holder the right, but not the obligation, to buy or sell a specified number of shares of a company's equity at a predetermined strike price before or on a specific expiration date. These financial instruments derive their value from an underlying asset, in this case, shares of a company. They offer flexibility, allowing investors to benefit from price movements without directly owning the shares initially. Share options are commonly used for speculation, hedging, and as a form of employee compensation.

History and Origin

While informal agreements resembling options have existed for centuries—dating back to ancient Greece and the Dutch Tulip Mania—the modern, standardized share options market began in the 20th century. A pivotal moment occurred with the establishment of the Chicago Board Options Exchange (CBOE) in 1973. This event marked the transition from unstandardized, over-the-counter options to centrally cleared, exchange-traded contracts with defined terms. The CBOE's efforts to standardize contract size, strike prices, and expiration dates, alongside establishing centralized clearing, significantly boosted the credibility and accessibility of share options for a wider market. Thi⁷, ⁸, ⁹s standardization, coupled with the development of sophisticated pricing models, transformed options trading into a legitimate and widely adopted financial activity.

##⁶ Key Takeaways

• Share options provide the holder the right, but not the obligation, to buy or sell shares at a specified price.
• Their value is derived from the price movement of the underlying shares.
• They are utilized for various purposes, including speculative trading, hedging against price fluctuations, and as a component of compensation packages.
• Share options allow for leveraged exposure to price movements of the underlying asset.
• The market for standardized share options gained prominence with the opening of the Chicago Board Options Exchange (CBOE) in 1973.

Formula and Calculation

While a simple formula for share options does not exist due to their complex nature, the most widely recognized and foundational model for pricing European-style options is the Black-Scholes model. Developed by Fischer Black, Myron Scholes, and Robert Merton, this model provides a theoretical framework for determining the fair option premium of an option. The⁵ model considers several key inputs, including the current price of the underlying share, the option's strike price, the expiration date, the risk-free interest rate, and the expected volatility of the underlying share. The⁴ Black-Scholes formula is complex, involving partial differential equations and statistical concepts to estimate the option's value based on these variables. It fundamentally separates the option's value into its intrinsic value and time value, reflecting both the immediate profit potential and the value derived from the remaining time until expiration.

Interpreting Share Options

Interpreting share options involves understanding their current value relative to the underlying share price and the likelihood of them becoming profitable. For a call option, which grants the right to buy, it is considered "in the money" if the underlying share price is above the strike price. Conversely, for a put option, which grants the right to sell, it is "in the money" if the underlying share price is below the strike price. The further an option is in the money, the greater its intrinsic value.

Beyond intrinsic value, share options also possess time value, which erodes as the option approaches its expiration date. A longer time to expiration generally means higher time value due to more opportunities for the underlying share price to move favorably. Traders and investors interpret option prices by evaluating these components, alongside factors like market volatility and interest rates, to gauge the option's potential profitability and associated risks.

Hypothetical Example

Consider an investor, Sarah, who believes that Company ABC's stock, currently trading at $50 per share, will increase in value. Instead of buying 100 shares for $5,000, she decides to buy a share option. She purchases a call option contract for 100 shares of Company ABC with a strike price of $55 and an expiration date three months from now. The option premium is $2 per share, totaling $200 for the contract ($2 x 100 shares).

If, by the expiration date, Company ABC's stock rises to $60 per share, Sarah's option is "in the money." She can exercise her right to buy 100 shares at $55 each and then immediately sell them in the market for $60 each.

• Cost of exercising: 100 shares * $55/share = $5,500
• Revenue from selling: 100 shares * $60/share = $6,000
• Gross profit from trade: $6,000 - $5,500 = $500
• Net profit: $500 (gross profit) - $200 (initial premium paid) = $300

If, however, Company ABC's stock only rises to $52, or drops below $55, the option expires "out of the money" and worthless. Sarah's maximum loss would be the initial $200 premium paid for the option, which is significantly less than the potential loss if she had directly purchased the underlying asset (the shares).

Practical Applications

Share options are widely used in financial markets and corporate strategy for various purposes:

• Speculation: Traders use share options to speculate on the future price movements of shares. A call option is bought if a price increase is anticipated, while a put option is bought if a price decrease is expected. This allows for magnified returns on a relatively small initial investment compared to direct share ownership.
• Hedging: Investors and companies use share options for risk management. For instance, an investor holding a stock portfolio might buy put options to protect against a potential decline in the value of their shares, similar to buying insurance.
• Employee Compensation: Companies often grant share options to employees, executives, and directors as part of their employee compensation packages. This incentivizes employees to contribute to the company's success, as the value of their options typically increases with the company's share price. For example, Tesla recently approved a significant share award to its CEO, Elon Musk, demonstrating the continued use of share options as a key incentive for leadership.
• ³ Income Generation: Investors can sell options (write options) to collect the premium, generating income, though this comes with obligations if the option is exercised.

Limitations and Criticisms

Despite their versatility, share options come with notable limitations and criticisms:

• Complexity: Share options can be complex financial instruments. Understanding their pricing dynamics, the impact of volatility, and various strategies requires significant financial knowledge. Misunderstanding can lead to substantial losses.
• Time Decay (Theta): Unlike direct share ownership, options have an expiration date. As an option approaches expiration, its time value erodes, a phenomenon known as "theta decay." This means that even if the underlying share price moves favorably, insufficient time may lead to the option expiring worthless.
• Dilution (for Companies): For companies issuing share options, particularly through employee compensation plans, the exercise of these options can lead to share dilution. This occurs when new shares are issued, increasing the total number of outstanding shares and potentially reducing the earnings per share and the value of existing shareholders' stakes.
• ² Executive Compensation Controversy: The use of share options in executive compensation has faced criticism for potentially encouraging short-term decision-making or excessive risk-taking to inflate share prices, benefiting executives at the expense of long-term company health. Furthermore, the timing of option grants relative to material nonpublic information has drawn scrutiny from regulators, necessitating detailed disclosure requirements.
• ¹ Limited Lifespan: An option's value is tied to its lifespan. If the anticipated price movement of the underlying asset does not occur within the specified period, the option expires worthless, resulting in the loss of the entire premium paid.

Share Options vs. Stock Options

The terms "share options" and "stock options" are often used interchangeably, leading to some confusion, but there is a subtle distinction in common usage. "Share options" is a broader term encompassing any derivative contract that gives the holder the right to buy or sell shares. This includes options traded on public exchanges (call option, put option) by individual investors for speculative or hedging purposes.

"Stock options," while technically a type of share option, typically refers specifically to those granted by a company to its employees, executives, or directors as a form of employee compensation. These usually come with a vesting period and are part of an incentive program, aligning employee interests with shareholder value. While both involve the right to purchase company shares at a set strike price, "share options" can refer to any such contract, whereas "stock options" commonly implies those issued by an employer.

FAQs

Q: Are share options considered risky?
A: Yes, share options can be risky, especially for buyers. While they offer high leverage and limited downside to the premium paid, they are subject to time decay and volatility. If the underlying share price does not move as anticipated before the expiration date, the entire option premium can be lost. Sellers of options face potentially unlimited losses depending on the type of option and strategy.

Q: How do share options benefit employees?
A: Share options serve as a significant form of employee compensation, incentivizing employees by allowing them to profit from the company's growth. If the company's share price increases above the strike price of their options, employees can exercise them, buy shares at a lower price, and potentially sell them for a profit. This aligns their financial interests with the company's performance.

Q: What is the difference between a call and a put share option?
A: A call option grants the holder the right to buy the underlying asset at a specified strike price before expiration. Investors typically buy call options when they expect the share price to rise. A put option grants the holder the right to sell the underlying asset at a specified strike price before expiration. Investors typically buy put options when they expect the share price to fall or to hedge an existing share position.