Stock Option Definition
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 aren’t 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.
A Little More on What is 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 buyer’s right to sell a Stock Option, on or before its expiry date, at a specified price, is called as Put Option.
Call Options – The buyer’s 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.
The practice of writing options to receive a premium as opposed to buying an option, is called ‘Writing Option’.
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.
References for Stock Options
Academic Research on Stock Options
Stock options for undiversified executives, Hall, B. J., & Murphy, K. J. (2002). Journal of accounting and economics, 33(1), 3-42. This paper examines the implications of granting Stock Options to conservative management executives who are traditionally risk-averse.
Do corporations award CEO stock options effectively?, Yermack, D. (1995). Journal of financial economics, 39(2-3), 237-269. This paper examines whether Stock Options are rewarded effectively to corporate CEOs.
Employee stock options, Huddart, S. (1994). Journal of Accounting and Economics, 18(2), 207-231. This paper takes a look at Employee Stock Options.
Optimal exercise prices for executive stock options, Hall, B. J., & Murphy, K. J. (2000). American Economic Review, 90(2), 209-214. This paper determines the best prices to exercise executive stock options granted in ‘at the money’ stage and discusses the economic rationale behind this practice.
Employee stock options, EPS dilution, and stock repurchases, Bens, D. A., Nagar, V., Skinner, D. J., & Wong, M. F. (2003). Journal of Accounting and Economics, 36(1-3), 51-90. This paper studies the relationship between earning per share (EPS) dilution, stock repurchases by company executives, and employee stock options.
Market valuation of employee stock options, Aboody, D. (1996). Journal of accounting and economics, 22(1-3), 357-391. This paper investigates the market valuation of employee stock options in terms of its effects on the stock price.
Are executive stock options associated with future earnings?, Hanlon, M., Rajgopal, S., & Shevlin, T. (2003). Journal of Accounting and Economics, 36(1-3), 3-43. This paper investigates the impact of executive stock option grants on future earnings of a firm.
Explaining executive compensation: Managerial power versus the perceived cost of stock options, Murphy, K. J. (2002). U. Chi. l. reV., 69, 847. This paper studies the impact of executive stock options compensation plans, its impact on corporate governance, managerial power, and the perceived value of the stock as a result.
Risk-neutral skewness: Evidence from stock options, Dennis, P., & Mayhew, S. (2002). Journal of Financial and Quantitative Analysis, 37(3), 471-493. This paper studies the various factors that impact the fluctuations in Stock Options on the Chicago Board Options Exchange to investigate their volatility skew.
The ‘repricing’ of executive stock options, Chance, D. M., Kumar, R., & Todd, R. B. (2000). Journal of Financial Economics, 57(1), 129-154. This paper investigates the practice of repricing Stock Options granted to executives and the circumstances that influence firms to resort to this practice.