Stock option
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.
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.
The most common way to trade stock options is trading standardized options contracts that are listed by various
futures and options exchanges 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.
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.
* Erik Lie and Randall A. Heron,
Does backdating explain the stock price pattern around executive stock option grants? ,
Journal of Financial Economics, 2006.
*
Are CEOs Paid for Luck, Marianne Bertrand and Sendhil Mullainathan,
Quarterly journal of Economics, 2001.
*
Are CEOs paid like Bureaucrats?, Brian Hall & Jeffrey Liebman,
Quarterly journal of Economics, 1998.
*
List of finance topics*
Derivative markets
**
Derivative (finance)***
Bond options
***
Credit derivatives
***
Foreign exchange options
***
Interest rate options
***
Warrant*
Options Backdating Information Center - ISS Comprehensive Information and Articles on the Options Backdating Scandal
*
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.
