Stock option

A stock option is a financial instrument that affords the holder the opportunity to purchase stock in a company at a predetermined price within a predetermined period. Alternately, stock options can be configured to give the option holder the choice to sell the stock at a specified price within a specified period. In both cases, the option holder can choose to exercise his or her right to buy or sell the stock at the preset price but is not obligated to do so.

Stock options can be traded on public exchanges, and they can be used by companies to compensate their employees. While stock options are frequently offered to high-ranking executives, they may be advanced to lower-ranking employees as a means of attracting and retaining the best available talent. Stock options can be an attractive alternative for new companies and start-ups that want to offer their employees competitive compensation packages but need to conserve their cash resources.

Background

Stock options belong to a broader group of investment vehicles known as options. Options essentially function as price predictors. Their value is determined by the probability that the underlying asset will reach or exceed the price level specified in the option contract by the specified date. Options can be granted not only on stocks but also on bonds, commodities, currencies, indexes, and other asset classes.

The two primary types of options are call options and put options. Call options allow the holder to buy the underlying asset, while put options allow the holder to sell the underlying asset. In both cases, the option's strike price (or exercise price) represents the market value the underlying asset must reach for the option to be exercised. The strike price is a critical factor in determining the market value of the option.

For example, consider two call option contracts for one share of stock in the same company, and suppose the first call option has a strike price set at $50, while the second call option has a strike price set at $75. Next, suppose that the company's stock is currently trading at $65. This means that the call option contract with a $50 strike price is worth $15, since it would afford the option holder the opportunity to buy one share of stock at $15 less than its current market value. Thus, it is what traders call being "in the money." The call option contract with a $75 strike price is "out of the money" by $10, since an investor would not exercise the option to buy one share of stock in a company for $10 more than the price for which it could be purchased on the open market. If the value of the company's stock does not reach at least $75 by the time the option expires, the second call option contract would have no value. Traders also use the term "near the money" to describe options that are approaching their strike price but have not yet reached it.

Put option contracts work the same way, but instead of looking for the value of the underlying asset to exceed the strike price, investors want the market value of the underlying asset to be below the strike price. This allows them to sell the asset at a premium on its current market value.

Overview

Put and call options are traded on public exchanges and can be bought and sold by investors at any time. Such investments are, by their very nature, highly speculative and carry a significant degree of risk, but they hold the potential to generate strong returns. With call options, the investor purchasing the option thinks the value of the underlying stock will increase by the time the contract expires, while the seller believes it will decrease. The reverse is true of put options; investors use them to try to profit from stocks that decline in value by securing the future right to sell the stock at a higher-than-expected price.

As traded on public exchanges, put and call stock options are usually denominated in contracts of one hundred shares of the underlying asset. In the United States, stock options can normally be redeemed at any point between the purchase date and expiration date. In Europe, stock options can usually be exercised on the expiration date only.

Employee stock options work slightly differently. Rather than having a specified expiration or maturation date, these stock options are usually set up so that the employee gains the right to exercise his or her option after working for the company for a specified amount of time. These are known as vesting options. Employee stock options substitute a valuation known as the grant price in place of the strike price. The grant price represents the price per share that the employee must pay to exercise his or her stock option. If shares of the company's stock are trading at values higher than the grant price when the option matures, the employee can make an immediate profit. Alternately, the employee could purchase and hold the shares in the hope that they will continue to increase in value.

Companies offer employee stock options not only to attract and retain employees but also for strategic reasons. Stock options give employees a stake in the company, which theoretically makes them more motivated to help the company succeed. Many companies have used stock options as an incentive. In some cases, employees that joined highly successful companies early on have earned fortunes through their stock options.

However, such stock options do come with potential drawbacks for companies and their employees. Companies that offer employee stock options risk weakening the equity of their other shareholders. If many employees exercise their options at the same time, the market becomes flooded with sellers of the company's stock. This, in turn, puts strong downward pressure on the company's share price, which can potentially cause other investors to lose money. For employees, stock options are only beneficial if the company's shares are publicly traded and rise in value above the grant price or if the company is bought by outside investors for a per-share price that is higher than the grant price. Otherwise, the stock options will never hold any value, making them effectively worthless and removing any incentive for owning them.

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