Stock option definition
/What is a Stock Option?
A stock option is a contract that allows its holder to either buy or sell a certain number of shares at a specific price and within a designated time period. A call option allows the contract holder to buy shares, while a put option allows the holder to sell shares. A call option is a commonly-used form of incentive compensation, while a put option can be used to mitigate the risk of negative price swings.
Characteristics of a Stock Option
The primary characteristics of a stock option are as follows:
Underlying asset. The stock option is tied to a specific stock (the underlying asset).
Strike price. This is the predetermined price at which the stock can be bought (call) or sold (put).
Premium. This is the price paid by the buyer of the option to the seller (writer) for the option contract.
Expiration date. This is the date by which the option must be exercised or it becomes void.
Contract size. This is a specification of the number of shares covered by the option, typically 100 shares per contract.
Underlying stock price. The price of the stock affects the value of the option.
Volatility. This is the degree of fluctuation in the underlying stock price; higher volatility generally increases the value of the option.
Time to expiration. This is the time remaining until the expiration date; options with more time tend to have higher premiums.
Example of a Stock Option
Mr. Jones believes that the price of the common stock issued by Verity Corporation will rise over the next few months. Therefore, he buys a call option with a $25 strike price, which is the threshold that Verity’s shares must surpass in order to generate a profit. A few months later, the price of Verity’s shares has risen to $45, so he exercises the option to acquire shares at $25 each, and then sells the shares on the open market at $45, resulting in a 20% profit per share sold.
Advantages of Stock Options
A major advantage of issuing stock options to employees is that it keeps them working for the company through the exercise period of the options. This is because they can benefit from exercising the options, as long as there is a sufficient increase in the company’s stock price to make it financially worthwhile for them to remain with the company. In addition, there can be a positive impact on employee morale, since they are facing the prospect of a potentially significant payout.