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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) a certain number of shares of stock, at a predetermined or calculable (from a formula in the contract) price.
Valuation
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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 the stock from whomever 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.
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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 put and call 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.
The estimate for future volatility is perhaps the least-known input into any pricing model for options, therefore traders often look to the marketplace to see what the Implied Volatility of an option is -- meaning that given the price of an option and all the other inputs except volatility you can solve for that value.
Trading
Options themselves are traded as securities. The most common way is trading standardized options contracts that are listed by various exchanges -- there are currently six options exchanges in the United States that list standardized options contracts based on underlying stocks -- The Philadelphia Stock Exchange (PHLX), American Stock Exchange (AMEX) in New York City, The Pacific Coast Exchange (PCX) in San Francisco, and the Chicago Board Options Exchange (CBOE) which are all open-outcry marketplaces, and the International Securities Exchange (ISE) and Boston Options Exchange (BOX) are electronic marketplaces.
There are also "over the counter" options contracts that are traded not on exchanges, but between two independent parties. At least one of those parties is usually a large financial institution with a balance sheet big enough to underwrite such a contract.
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.
Options can also be traded to capture a certain level of volatility on an underlying security.
Employee Stock Options
Main article: Employee stock option
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 employees an incentive to help the company become more profitable. For details see the employee stock option article.
See also
External links
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