Definition: The Stock Option is a security that gives the right to its holder, but not the obligation to buy or sell the outstanding stocks at a specific price and a specific date. The stock options are traded on the securities exchange like other shares.
People purchase these stock options if they believe that the stock price is likely to go up or down in the near future. For example, if today the stock trades at Rs 1000 per share and is expected to increase in the next month to Rs 1200 per share, then you will buy the call option today at Rs 1000, so that you can sell it at RS 1200 in the next month and make a profit of Rs 200 on each share purchased.
A stock option is a contract in which following terms are included:
- The type of stock option There are two types of options, call option and put option. The call option gives the buyer the right not the obligation to buy the underlying stock, while the put option gives the right and not the obligation to sell them. One who buys the options are called as holders, whereas the ones who sell these, are called as writers.
- Strike Price is the price at which the option holder can buy or sell the underlying asset when the option is exercised.
- Option Premium, an amount paid to acquire the options. The option buyer has to pay a premium to the option seller for carrying on the risk. The amount of premium depends on the strike price, volatility of change in the price of underlying assets and the time period till the option expires.
- In a contract, the date on which the option expires is clearly mentioned. Thus, every option comes with an expiration date after which the options become worthless, and the holder has no right to exercise it.
- There are two types of option styles according to which the options can be exercised. The American Style and the European Style. The American-style options can be exercised anytime before the expiration date, whereas the European style options can only be exercised on the expiration date itself.
- The security for which the option seller has the obligation to deliver or purchase from the option buyer is called the underlying asset. Thus, the underlying asset for which the whole options contract is made is clearly mentioned therein. For example, if there are stock options, then the underlying asset is the shares of the specific company.
- The contract must include the “multiplier” which means the quantity of the underlying asset that needs to be delivered at the time option is exercised.
The stock options are also issued to the specified employees of the company and are called as the Employee Stock Options.