Wednesday, October 7, 2009

Stock Options

Option (finance): In finance, an option is a contract between a buyer and a seller that gives the buyer the right—but not the obligation—to buy or to sell a particular asset (the underlying asset) at a later day at an agreed price. In return for granting the option, the seller collects a payment (the premium) from the buyer. A call option gives the buyer the right to buy the underlying asset; a put option gives the buyer of the option the right to sell the underlying asset. If the buyer chooses to exercise this right, the seller is obliged to sell or buy the asset at the agreed price. The buyer may choose not to exercise the right and let it expire. The underlying asset can be a piece of property, or shares of stock or some other security, such as, among others, a futures contract. For example, buying a call option provides the right to buy a specified quantity of a security at a set agreed amount, known as the 'strike price' at some time on or before expiration, while buying a put option provides the right to sell. Upon the option holder's choice to exercise the option, the party who sold, or wrote the option, must fulfill the terms of the contract.
Every financial option is a contract between the two counterparties with the terms of the option specified in a term sheet. Option contracts may be quite complicated; however, at minimum, they usually contain the following specifications:
  • whether the option holder has the right to buy (a call option) or the right to sell (a put option)
  • the quantity and class of the underlying asset(s) (e.g. 100 shares of XYZ Co. B stock)
  • the strike price, also known as the exercise price, which is the price at which the underlying transaction will occur upon exercise
  • the expiration date, or expiry, which is the last date the option can be exercised
  • the settlement terms, for instance whether the writer must deliver the actual asset on exercise, or may simply tender the equivalent cash amount
  • the terms by which the option is quoted in the market to convert the quoted price into the actual premium–the total amount paid by the holder to the writer of the option.
Types of Options:

The primary types of financial options are:

§ Exchange traded options (also called "listed options") are a class of exchange traded derivatives. Exchange traded options have standardized contracts, and are settled through a clearing house with fulfillment guaranteed by the credit of the exchange. Since the contracts are standardized, accurate pricing models are often available. Exchange traded options include:[4][5]

1. stock options,

2. commodity options,

3. bond options and other interest rate options

4. stock market index options or, simply, index options and

5. options on futures contracts

§ Over-the-counter options (OTC options, also called "dealer options") are traded between two private parties, and are not listed on an exchange. The terms of an OTC option are unrestricted and may be individually tailored to meet any business need. In general, at least one of the counterparties to an OTC option is a well-capitalized institution. Option types commonly traded over the counter include:

1. interest rate options

2. currency cross rate options, and

3. options on swaps or swaptions.

§ Employee stock options are issued by a company to its employees as compensation.

Employee Stock Option:

An employee stock option is a call option on the common stock of a company, issued as a form of non-cash compensation. Restrictions on the option (such as vesting and limited transferability) attempt to align the holder's interest with those of the business' shareholders. If the company's stock rises, holders of options experience a direct financial benefit. This gives employees an incentive to behave in ways that will boost the company's stock price.

Employee stock options are mostly offered to management as part of their executive compensation package. They are also offered to lower staff, especially by businesses that are not yet profitable. They can also be offered to non-employees: suppliers, consultants, lawyers and promoters for services rendered.Employee stock options (ESOs) are non-standardized calls that are issued as a private contract between the employer and employee. Over the course of employment, a company generally issues vested ESOs to an employee which are struck at a particular price, generally the company's current stock price. Depending on the vesting schedule and the maturity of the options, the employee may elect to exercise the options at some point, obligating the company to sell the employee its stock at whatever stock price was used as the strike price. At that point, the employee may either sell the stock, or hold on to it in the hope of further price appreciation or hedge the stock position with listed calls and puts.

Types of Employee Stock Options:

In the U.S., stock options granted to employees are of two forms, that differ primarily in their tax treatment. They may be either:

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