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.
Suppose I 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, making a profit of $5.
However, if, in one month's time the stock price was only $95, I would not exercise my option, for 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 own an option, I might make a profit but am certain not to make a loss, except for the cost of the option itself. The principle of no arbitrage therefore implies that an option must have some positive monetary value itself.
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,
The estimate of the future volatility of the stock price.
For large corporations in economies such as the United States, there is a liquid market in european put and call stock options for certain expiry dates and certain strikes close to the current stock price. Thus for those contracts valuation is given "by the market". For other contracts, with different strikes and different expiries the market price can be used to give an estimate of the future volatility, which in turn can be used in models such as the binomial options model (for American options) or the Black-Scholes model with volatility smile for European options to value the non-standard contracts.
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.
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. For details see the employee stock option article.
Who Really Cooks the Books? (http://www.nytimes.com/2002/07/24/opinion/24BUFF.html) (Opinion piece by Warren Buffett, generally regarded as being sceptical about derivatives, in the New York Times, July 24, 2002)
The Open Site Encyclopedia section on Options (http://open-site.org/Business/Investing/)
Shares and share unlike (http://www.economist.com/displayStory.cfm?Story_ID=230106&CFID=1608647&CFTOKEN=8842676) - 1999 article from The Economist questioning whether investors (as owners) actually gain from large option packages for top management.
Stockoptions are sometimes jokingly referred to as "golden handcuffs" (in the same vein as golden handshakes or golden hellos), especially in a strongly rising market - the employee may feel compelled to work out the time until they are able to liquidate the stock even if they might otherwise prefer to leave the company.
Those who are against stockoption expensing say that the diluted earnings per share metric (the amount of income divided by all outstanding shares and all shares that would theoretically exist if all the stockoptions were used) clearly shows the economic effect of stockoptions.
Because most employee stockoptions are nontransferrable, are not immediately exercisable, and have other restrictions, the IRS considers that their "fair market value" cannot be "readily determined", and therefore "no taxable event" occurs when an employee receives an option grant.
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