Business Basics for Engineers by  Mike Volker Stock Options (market) Contact: Mike Volker, Tel:(604)644-1926, mike@volker.org

This article is about tradable stock options - i.e. the ones that trade on a stock exchange - not  those which are generally referred to as incentive stock options (as in employee compensation plans). 

I'm sure you've heard about stock options. There are also options on things like commodities, currencies, etc. But, herein we'll discuss only stock options. So what is an option? A stock option is a right to buy or sell a particular stock at a set price on or before a specified expiration date. A "call" option is the right to buy a specific stock at a set price until a specified date, known as the "expiration" date. After the expiration date the option is of no value or use. A "put" option is the right to sell a specific stock until the expiration date. Options have many useful purposes. Options are created or "written" by investors, speculators, and companies. Options can be traded just like stocks are traded on a stock exchange. Options are often called a "derivative" security - meaning that they are derived from some underlying security.

Companies often grant stock options to their senior employees as a way to compensate them for their contribution to the growth of the company. For example, Northern Telecom may grant a senior manager an option to buy 100,000 shares of NorTel at $65 per share for a period of two years. The exercise price is usually set at some price close to the current market price (which is presently $68/share). Companies are not allowed to set the price significantly below the market - for obvious reasons! If after one year, NorTel is trading at $75, the option holder could sell 100,000 shares at $75 and simultaneously buy 100,000 shares at $65 by exercising the option - thereby making a net profit of $10 per share or $1,000,000 in total - not bad for a year's hard work!! This is a great way to recruit and motivate talented managers! [NB - yes, at one time NorTel shares were trading at this price!]

On the investment side, a shareholder who owns NorTel stock, could "write" call options - i.e. sell options to other parties which would give them the right to buy NorTel at $70 up until a given expiry date, say the third Friday in Oct96. If the selling price is $2.50, then the shareholder would net $2,500 if he wrote 10 option contracts (1 contract = 100 shares). If NorTel stock rose above $70 before the expiry date, that shareholder would be obligated to sell his stock. (He could also buy back the option if he didn't want to sell the stock.) However, in this case the investor makes money in two ways - from selling the option (100% profit on this) and from selling the stock itself at $70 (assuming, of course, he paid less than $70 per share). If the stock does not rise above $70, the option expires worthless and the shareholder has made an extra $2.50 per share return on investment by writing the option. This is a good way to generate additional income by holding a security.

Check the section on the newspaper called "Canadian Equity Options" - you can see the various options that have been created by investors and which are currently available for trading. Options not shown can still be created or written by investors. Note - the companies do not create these - only the investment community.

Speculators in the market often trade, i.e. buy and sell, options. For example - if you really like NorTel and think that the stock will soar - you can buy call options instead of actually buying the stock. Using the above example, you could buy the Oct96 $70 Call options for $2.50. If NorTel goes to $80 before the expiration date, your options are inherently worth $10.00 and you have just made a 400% return on your $2.50 investment. Not bad! BUT - very risky because those options have a time fuse on them and could expire worthless. Options are a good way for investors to bet on Companies with high share prices - i.e. you can bet on NorTel by putting up only nickels and dimes.

Similarly, if you thought that NorTel was having some problems and if you think that the stock will plummet, you can buy "put" options. A PUT allows you to sell the stock at a certain price. For example a NorTel $65 Put could be bought for $.25. If NorTel sewers to $60, you have just made a whopping $5 on only $.25 investment. Very spectacular - and very speculative. So who would ever sell a put option, you ask. Well, it could be a speculator who thinks that NorTel will rise and that the put option will expire worthless. Or, it could be a shortseller of NorTel who is using the put to provide some extra income (just like the stockholder above used calls to generate extra income).

As an example, consider Henry Stephen, a trader at Nesbitt Burns Inc. He turned $10,000 into a windfall of $280,000 by buying and selling stock options. He bet correctly on the direction of NorTel's shares. He was betting that NorTel would drop when he bought 300 July $70 put options. Starting June 10, he built up his position even though NorTel climbed to a 52-week high of $76.10 on July 4th. Each time the stock went up, the puts were cheaper to buy. He bought the first ones at $1.00 and bought the same ones on July 8th for 15 cents each. On July 15th, NorTel dropped to $67.70 and he started selling puts tat $2.15 each. Eventually, the stock dropped further and the puts were worth $7.40. A few days later, the stock was back at $72 and the puts were worthless. So - timing is everything when it comes to options. As you can see, they provide tremendous leverage but are very risky.

So, if that's what an option is, what is a warrant? A warrant is, in concept, very similar to an option. Warrants are usually options which are granted by companies (as opposed to being created by the market) to their investors. For example, investors may be given a warrant, i.e. the right, to buy shares from the Company at a given price until a specified date. The warrants themselves trade on an exchange. They are usually listed along with the stock trading (not in the options section of the papers). When warrants are exercised, the exercise price provides the company with new equity capital and the company, especially if it is a junior, benefits greatly from the increased working capital. Warrants are often used by companies as a means for providing "built-in" financing as they grow and require more capital.

Mike Volker is the Director of the University/Industry Liaison Office at Simon Fraser University, Chairman of the Vancouver Enterprise Forum, and a technology entrepreneur.