Stock Options
A stock option is a contract between a buyer and a seller. There are two types of stock options, calls and puts.
Owning a “call” gives you the right to purchase a certain number of shares of a stock at a certain price (strike price) up to the date that the option expires. If stocks options are not exercised by their experation date, they expire worthless. Stock options are written for blocks of 100 shares. So a single call is a contrant to buy 100 shares of a stock at the strike price on or before the expiration date.
Example: Lets say John owns a call for 100 shares of XYZ stock at a strike price of $4. The price of XYZ stock was only $3.50 when he purchased the calls. But sometime before the experation date, XYZ stock jumps to $10 a share. John exercised his calls, and purchases 100 shares of XYZ for $4 each, for a total cost of $400. But the shares are worth $10 each, so he now owns $1000 worth of XYZ.
A “put” gives the owner the right to sell a certain number of shares of a stock for a certain price anytime before the expiration date. Like calls, if puts are not exercised before the expiration date, they expire worthless. A single put is a contrant to sell 100 shares of a stock at the strike price on or before the expiration date.
Example: John owned 100 of ABC stock. He bought the shares for $10 each, but was concerned the price of the stock might drop. So he bought puts to sell his stock for $8. Sometime before the expiration date of the puts, the stock price of ABC plummets to $1 a share. He exercises his puts, and sells his shares of ABC for $8 each. His puts protected him to the tune of $700.
If someone can buy stocks options such as calls and puts, it reasons that someone has to sell the calls and puts.
Example: Lets say John owns 100 shares of XYZ stock, and decides to sell a call on it. The stock is currently selling at $10 a share, so he sells a call with a strike price of $12. He makes a small amount of money from the sale of the call. Since John owns the 100 shares of XYZ stock, this is a covered call. If the stock price goes above $12 before the call expires, say to $15 a share, there is a good chance the call will be exercised, and John will have to sell his 100 shares of XYZ stock for the contracted $12 strike price. If the call is never exercised, John keeps the money he made from selling the call, and he is free to sell another call on his stock.
Example: Lets say John doesn’t own any XYZ stock at all. He can still sell a call on the stock. This is a naked call. Let’s say the stock was selling for $10 when he sold the call with a strike price of $12. If the call is never exercised, he makes some money. But lets say the stock jumps to $15 a share, and the call is exercised. Ouch! John will be forced to buy 100 shares of XYZ stock for $1500, and sell it back to the contract holder for $1200. What if the stock had gone up to $100 a share? There is no limit to how high the stock can go. So John’s losses are theoretically unlimited. Naked calls are very risky!
John could also sell puts. Lets say XYZ stock is selling for $10 a share. John sells a put for 100 shares with a strike price of $8. This means he is promising to buy 100 shares of XYZ at $8. If the stock stays above $8 it is unlikely the put will be exercised. If the stock drops to $1 a share, and the put is exercised, John will have to buy 100 shares of XYZ stock for $800 even though it is now only worth $100. If the stock never falls below $8, and the call is not exercised, then John keeps the money he sold the put for, and he can do it again. This is less risky than selling a naked call as John’s losses are limited to $800. Even is the stock dropped to $0, the most John would lose would be the $800.

Incentive Stock Options
Sometimes companies will give it’s employees stock options. This is a called a stock option grant. The grant price is usually the market price of the stock. These stock options may have vesting periods. So that the stock options are granted, the employee is 0% vested. There maybe be a graduated vesting. So after 1 year, the employee is 25% vested. After 2 years 50% vested, 3 years 75% vested, and 4 years, the employee will be 100% vested. If the employee leaves the company, he has very brief time in which to exercise the stock options. They are call incentive stock options, because they are intended to be an incentive for the employee to stay and make the company more profitable so that the stock options are worth more money. Kind a profit sharing kind of thing.
Example: John works for XYZ company. XYZ company decides to grant it’s employees 100 shares of XYZ stock with a grant price of $10. John continues working for XYZ company. After two and half years, the stock rises to $15. John is 50% vested. He decides to exercise 50% of his stock options. He buys the 50 shares of XYZ stock for $10 each. He can either keep the 50 shares, or he can immediately turn around and sell the 50 shares for the $15 market price for an instant profit of $250 (50 x $5). John still has stock options left for 50 shares. These are currently unvested.

Hopefully this sheds light on what stock options are, and how they work.