Standardised vs. Employee Stock Options: Key Differences

Apart from equities, bonds and commodities, investors turn towards derivative trading to diversify their portfolio and profit from the price fluctuations of their assets. If you are not an investor or an employee of a large company, learning about derivatives may seem futile. However, if your company is planning to go public in the future, you will most likely be offered ‘c (ESOPs).

As ‘Options’ are an important financial instrument included in derivatives trading, employee stock options are best understood by learning about derivatives and their sibling called Options. Let’s break down the concept of derivatives, options and the difference between standardised options and employee stock options.

What are Derivatives?

Derivatives are standardised financial contracts traded in stock exchanges in a regulated manner. They are subject to the rules put forth by market regulators such as the Securities and Exchange Board of India (SEBI) in India or the Securities and Exchange Commission in the USA. They are essentially contracts, deriving values from the price fluctuations of their underlying assets such as stocks, commodities etc.

These derivatives are traded through two methods: one that is subject to standardised terms and conditions, and hence being traded in the stock exchanges, and the second type being traded between private counter-parties, in the absence of a formal intermediary. While the first type is known as Exchange Traded Derivatives (ETDs), the second is known as Over the Counter (OTC) derivatives.

What are the types of Derivatives?

As derivatives have an inverse price relationship with many asset classes, derivative trading makes up for an ideal investment to hedge against the falling prices of other asset classes. Derivatives are of the following two types:

This is all about options contracts in a nutshell. Read on to learn about the difference between standardised options and employee stock options.

• Futures Contract: A futures contract is an agreement between the buyer and the seller of a particular asset. The buyers purchase a specific quantity of the asset at a predetermined price payable at a specific time in the future. This contract remains until maturity, and investors can sell them if the price has risen at the time of the expiry to make a profit.

• Options Contract: An options trading contract is generally permitted in top assets wherein the trader has the right but not a legal obligation to buy/sell the purchased security at a fixed price. Such a contract helps investors to make a profit based on price fluctuations without having to actually buy/sell the contract.

What are Standardised Options?

A standardised options contract or an exchange-traded contract is a type of derivative traded through a stock exchange and settled through a clearinghouse. Such contracts give the buyers and sellers the right, but not the obligation to buy and sell the contract until the contract expires.

For example, let’s say a farmer is worried that the price of the type of pulse he is growing may fall in the next three months. He can create an options contract with 1,000 kg of the pulse at Rs 100 per kg to mitigate his future losses. Now, if the pulse price dips to Rs 80 in the next three months, the farmer may exercise his right to sell and save himself a loss of Rs 20 per kg. However, if the pulse price rises to Rs 150 per kg, he may call off the right to sell as he is not obliged under the contract. The only expense he has to cover is the premium amount paid to exercise the options contract obligation.

The above example was a straightforward working process of a standardised options contract. However, there is a different type of options contract that is offered to an employee of an organisation.

What are Employee Stock Options?

One of the most important goals of a company is to be a public listed company. From the day it starts operating as a private company, employees contribute highly to its growth and ensure that it reaches a high profitability level. Once it does, the company starts to implement its expansion goals to let the company reach new heights. However, to achieve expansion goals, a private company needs funds that it can receive through a bank loan or through an IPO.

Most companies that are profitable and believe that they have reached a level of recurring business choose IPOs as a way of raising funds. An Initial Public Offering is the process by which a private company offers its shares to the public for the first time. After doing so, it becomes a publicly listed company and can use the raised funds for business purposes.

When a company decides to file for an IPO, it may offer its equity shares to its employees known as Employee Stock Options. They are offered to the employees of a company before it goes public. Instead of offering shares directly, employee stock options are extended as derivative options on the stock.

Derivative options in employee stock options entail that the employees have the right but not the obligation to buy the shares of the company at a predetermined price for a specific period of time. The employees may or may not choose to buy the shares depending on their risk exposure or company analysis.

How does employee stock options work?

Companies offer employee stock options to their employees within their equity compensation plan. They believe that it gives them an edge to mitigate employee turnover and motivate employees to do better. However, most employee stock options come with some restrictions, one of the most important being the vested period.

The vested period is the maximum time employees must hold the employee stock options before they can exercise the right to sell the shares. Usually, this period ends after the company files for an IPO, and the employees can sell the stocks on the open market. If not, they can hold the employee stock options for a long time and sell when the shares are trading at a profit.

What are the two types of employee stock options?

Following are the two types of employee stock options offered to employees in India:

• Employee Stock Purchase Plan (ESPP): Under the employee stock purchase plan, a company offers its employees the option of purchasing company shares at a lower price than their market value. In return, the employees are expected to serve the company for a predetermined minimum period.

• Restricted Stock Units (RSUs): Restricted stock units are a type of employee stock option where employees are granted the shares of the company only after the fulfilment of a specific condition or after the occurrence of an event. Generally, there is no vesting period for the shares granted under the RSU.

If you are an investor or are looking to invest in the stock market, you can look towards standardised options to hedge against the risk of other asset classes and make a profit. For every transaction that requires you to hold stocks, you would need a Demat and a trading account, best opened with IIFL. The Demat cum trading account gives you the benefit of seamless trading and investor-oriented research reports, allowing you to be a professional trader.