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Stock Options: High Risk, High Reward

I got my start on Wall Street back in 1984, as a floor runner for Bear Stearns on the Philadelphia Stock Exchange.
Considering the complexity of stock options – the trading vehicle of choice on the PhilEx – and considering that I knew nothing about them, I’m lucky I made it out alive.
Some background: A stock option is a specific type of option with a stock as the underlying instrument, (the security that the value of the option is based on). An option is a contract to buy (known as a “call” contract) or sell (known as a “put” contract) shares of stock, at a predetermined or calculable price.
For example, you could own an option to buy a share in XYZ corp. for $100 in one months' time. If the actual stock price at the time is $105 then you would exercise (i.e. use) your option and buy a stock from whoever sold you the option for $100. You could then either keep the stock, or sell it on the open market for $105, netting a profit of $5.
However, if, in one month's time, the stock price was only $95, you would not exercise your option, and if you really wanted a share in XYZ Corp, you could buy it in the open market for $95 rather than using your option to buy it for $100. If you have an option, you might make a profit and are certain not to make a loss. This means an option must have some positive monetary value itself.
A stock option contract's value is determined by five principal factors - the price of the stock, the strike price, the cumulative cost required to hold a position in the stock (including interest + dividends), the time to expiration, and an estimate of the future volatility of the stock price. Options themselves are traded as securities.
You have also probably heard of “Employee Stock Options.” Stock options for a company's own stock are often offered to upper-level employees as part of their compensation package. Non-executive employees are occasionally offered options, especially in the technology sector, in order to give all employees an incentive to help the company become more profitable and to lure quality employees to work.
Employee stock options differ from the options that are traded on exchanges as securities primarily in the time frame under which they can be exercised. Employee stock options typically allow an exercise timeframe of up to ten years, while exchange traded options typically expire within 2 years.
Me? I prefer employee stock options, primarily because, since your company pays you to take them, you can’t lose your own money on them. They may plummet and lose all their value, and that is regrettable, yes. But you don’t lose money out of your own pocket when that happens.
Put-and-Call-type Stock options are another story. Once it’s your money, and your risk, the stakes get higher. So be careful when you play the options game.

Published Sep 20 2006, 07:00 PM by moneycoach
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