Stock option

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Main article: Option

A stock option is a specific type of option that uses the stock itself as an underlying instrument to determine the option's pay-off (and therefore its value). Thus it is a contract to buy (known as a "call option") or sell (known as a "put option") a certain number of shares of stock, at a predetermined or calculable (from a formula in the contract) price.

Valuation

Example

Suppose I own an option to buy a share in XYZ Corp. for $100 in one month's time. If the actual stock price at the time is $105, then I would exercise (i.e., use) my option and buy the stock for $100 from whomever sold me the option. 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 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

The most common way to trade stock options is trading standardized options contracts that are listed by various futures and options exchanges -- there are currently six 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 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. In Europe the main exchanges where stock options are traded are Euronext.liffe and Eurex.

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

• List of finance topics
• Derivative markets
• *Derivative (finance)
• ** Bond options
• ** Credit derivatives
• ** Foreign exchange options
• ** Interest rate options
• ** Warrant

External links

• [Disk Lectures], Options I audio lecture with slideshow
• [Shares and share unlike] - 1999 article from The Economist questioning whether investors (as owners) actually gain from large option packages for top management.

 

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From Wikipedia, the Free Encyclopedia. Original article here. Support Wikipedia by contributing or donating.
All text is available under the terms of the GNU Free Documentation License See Wikipedia Copyrights for details.

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