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For example I may 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 a stock from whoever sold me the option for $100. I could then either keep the stock, or sell it in the open market for $105, realising a profit of $5.
However, if, in one month's time, the stock price was only $95, I would not exercise my option, and 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 have an option, I might make a profit and am certain not to make a loss. This means 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, and an estimate of the future volatility of the stock price. The most general method in wide-spread use for valuing stock options is the Binomial options model, although the Black-Scholes model can give accurate answers for certain types of options.
Options themselves are traded as securities on stock exchanges. 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.
Main article at 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 emplyees an incentive to help the company become more profitable. Because stock prices are related to corporate earning, the employees have an incentive to increase earnings, in order to make the price of the company's stock rise, and therefore increase the value of the employee's stock options. This increase in earnings can either be done in reality, or possibly by the use of creative accountingCreative accounting refers to accounting practices that deviate from standard accounting practices. They are characterized by excessive complication and the use of novel ways of characterizing income, assets or liabilities. This results in financial repor.
Employee stock options differ from the options that are traded on exchanges as securities primarily in the time frame under which they can be exercised. Employee stock options typically allow an exercise timeframe of up to ten years, whereas the longest time to expiry for exchange traded options is typically 2 years. Thus employee stock options are similar to warrantsA warrant is the right — but not the obligation — to buy or sell a certain quantity of an underlying instrument at an agreed-upon price. The right to buy the underlying instrument is referred to as a call warrant; the right to sell it is known as a put wa.
Stock options granted to employees are of two forms, that differ primarily on their tax treatment. They may be either:
According to current GAAPGAAP is an acronym for Generally Accepted Accounting Principles. There are two sets of principles, one for the United States and the other for the United Kingdom. US generally accepted accounting principles UK generally accepted accounting principles., stock options granted to employees do not need to be charged as an expense on the income statementElements of the income statement used in accounting are net income results from revenue, expense, gain, and loss transactions. Revenues Inflows or other enhancements of assets of an entity or settlements of its liabilities during a period from delivering when granted. This allows a potentially large form of employee compensation to not show up as an expense in the current year, and therefore, currently overstate income. Many assert that over-reporting of income by methods such as this by American corporations was one contributing factor in the Stock Market Downturn of 2002.
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