Stock Option - Explained
What is a Stock Option?
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Table of ContentsWhat is a Stock Option?Mechanics of a Stock OptionPut Options and Call OptionsWriting OptionsWhat are Employee Stock Options?Academic Research on Stock Options
What is a Stock Option?
Stock Options are units of shares that are sold or purchased at a predetermined price within an agreed upon duration. Traders can exercise these options but are not obliged to buy or sell them. Stock Options make up a large chunk of shares traded in the American stock exchange and can be redeemed at any time before the date of expiry and after the date of purchase. United Kingdom and Europe restrict the sale of Stock Options to the date of expiry. These Options, also known as Share Options cannot be sold or bought at any time in the European stock exchanges.
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Mechanics of a Stock Option
Stock Options are a cluster of shares of the underlying stock, commonly available in units of 100. If the value of a share is $10, and the Stock Options consist of 100 shares of $10, then buying one unit of this Stock Option would cost $1000. (10*100). This price is exclusive of transaction costs.
Put Options and Call Options
Put Options - The buyers right to sell a Stock Option, on or before its expiry date, at a specified price, is called as Put Option.
Call Options - The buyers right to purchase a Stock Option, on or before its expiry date, at a specified price, is called as Call Option. Call Options are purchased when the price of the stock is set to increase. This way, the buyer can purchase the stocks at below market prices and sell them at a premium. For e.g., the Strike Price of a Stock Option is $100, and a buyer purchases it for $1. The unit is sold for $120, netting the buyer a profit of 20 cents per share. Hence the Call Option enables the buyer to make an immediate profit of $20 on one Stock Option unit. If the cost of the underlying shares decreases, maximum loss incurred is the cost of the option paid by the buyer. Put Options are bought when the trader expects the price of the underlying stock to decrease. This allows the trader to sell the Stock Option at the Strike Price before it expires. From the example above, if the Strike Price of an Option is $100, and it is purchased for $1, and the price per share falls to 75 cents, the seller makes a profit of 25 cents per share by selling it at Strike Price, i.e., $100. If the underlying shares increase in price, maximum loss incurred is the cost of the options paid by the trader. In both cases, keeping an eye out on the Strike Price is important. It is relative to the current price of the underlying shares. It is the agreed upon price for purchase or sale of Options. Fluctuations in the underlying share price and time value also play an important role in determining the value of a Stock Option. Higher the volatility, costlier the Options. Longer time durations until expiration of the Options also increase its price. Conversely, stable prices and less time until expiry of Options reduces their price.
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The practice of writing options to receive a premium as opposed to buying an option, is called Writing Option.
What are Employee Stock Options?
Employee Stock Options differ from regular Call and Put Options in their maturity structure. Instead of having an expiration date, they adhere to a vesting schedule for employees to receive the Options. The right to exercise Employee Stock Options is contingent upon an employees continued employment with the Stock Option awarding firm until the Options are vested. Grant Price is used instead of Strike Price to determine profitable exercising of Stock Options.