Share Options in the Major Stocks

SHARE OPTIONS IN THE STOCKMARKET

The principal business of stock exchanges is trade in physical shares, but they also trade in share options in the major stocks. An option gives the holder the right to buy or sell a share at a predetermined price at some point in the future – for example, the right to buy shares in three months’ time at a price set today. An option which gives the buyer the right to buy a share is a “call” option. An option which gives the buyer the right to sell a share is a “put” option. The specific share on which an option is placed is called the underlying asset. The price at which the underlying asset is to be bought or sold is called the strike price or exercise price. The buyer of an option is not obliged to either buy or sell the underlying asset; it is only a right that can be exercised. The originator of an option, the option writer, must be able to carry out its side of the transaction, should the option holder exercise its right. Most options traded on exchanges are not settled by physical delivery but by a payment of the value of the option at expiry. The value is the difference between the option price and the current market value. This value is either:

• out-of-the-money (worth zero), in which case the asset can be purchased for less than the option price - for example, an option conferring the right to buy shares at $5 when they are trading at only $4.50; or
• In-the-money, in which case the option price is lower than the market price – for example, an option to buy shares at $5 though the market price is now $7.

Traded options bought on exchanges are a means of having exposure to share performance without having to invest the capital required to buy the stock. The risk is much greater with options as they expire on a fixed date and may end up being worthless. Some companies issue share options to senior staff as part of incentive and retention packages. For example, senior managers may be offered a right to buy shares in their company in five years’ time at today’s share price. This gives them an incentive to work hard, create shareholder value and share in the reward. If the share price rises over the five years, on expiry of the option the company will issue additional shares at the predetermined price. This will of course dilute the ownership percentages and the value of holdings for existing investors, but in practice the effect is minimal and is more than compensated for by the focus management has on driving value creation. The effect of these staff options will potentially lower the earnings per share. The normal calculation is to divide the earnings by the number of shares in issue, but there is another calculation that brings the effect of all the staff share options being exercised and turning into additional shares.

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