Stock option Guide, Meaning , Facts, Information and Description
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). Thus it 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 (from a formula in the contract) price.
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2 Valuation 3 Trading 4 Employee Stock Options 5 See also 6 External links |
Example
For example I may 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 I would exercise (i.e. use) my option and buy a stock from whoever sold me the option for $100. I could then either keep the stock, or sell it in the open market for $105, realising a profit of $5.
However, if, in one month's time, the stock price was only $95, I would not exercise my option, and if I really wanted a share in XYZ Corp, I could buy it in the open market for $95 rather than using my option to buy it for $100. Thus if I have an option, I might make a profit and am certain not to make a loss. This means an option must have some positive monetary value itself.
Valuation
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. The most general method in wide-spread use for valuing stock options is the Binomial options model, although the Black-Scholes model can give accurate answers for certain types of options.
Trading
Options themselves are traded as securities on stock exchanges. Options trading, without intent to ever exercise the option, can be used as a form of leverage. The price of an option on a security will move more than the price of the security itself. For this reason and due to their usefulness in financial engineering, the total value of trading in options has at times exceeded the total value of trading in stocks themselves.
Employee Stock Options
Main article at Employee stock option
Stock options for the company's own stock are often offered to upper-level employees as part of the executive compensation package, especially by American business corporations. It is also sometimes done for non-executive employees, especially in the technology sector, in order to give all emplyees an incentive to help the company become more profitable. Because stock prices are related to corporate earning, the employees have an incentive to increase earnings, in order to make the price of the company's stock rise, and therefore increase the value of the employee's stock options. This increase in earnings can either be done in reality, or possibly by the use of creative accounting.
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, whereas the longest time to expiry for exchange traded options is typically 2 years. Thus employee stock options are similar to warrants.
Types of Employee Stock Options
Stock options granted to employees are of two forms, that differ primarily on their tax treatment. They may be either:
Expensing of Employee Stock Options
According to current GAAP, stock options granted to employees do not need to be charged as an expense on the income statement when granted. This allows a potentially large form of employee compensation to not show up as an expense in the current year, and therefore, currently overstate income. Many assert that over-reporting of income by methods such as this by American corporations was one contributing factor in the Stock Market Downturn of 2002.
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