In the modern stock markets, the trade of securities is not just restricted to that of stocks or shares. However, to facilitate and finance modern business organizations, there are several other newer, developed, hybrid securities which are traded by investors in stock markets across the world. The concept of stock options is a sort of up-gradation of the normal share or common stock. Being a hybrid share, the only perquisite of creating a stock option is that there needs to be a share/stock in existence.
(Note: In the United States and some selected North American and European countries, a common stock i.e capital of company, is referred to as a 'stock', in contrast to that, in case of the British Commonwealth nations and some European nations, common stock is referred to as 'shares')
Definition and Meaning
The definition of stock options goes as follows...
'A stock option is an agreement and a legally binding contract between two parties, wherein one party gets the right but not the obligation to buy or sell a said stock to the other party at a predetermined and agreed price, within said period of time or on a specified date.'
The common details and characteristics of how stock options work and operate goes as follows:
- When a contract is made between two parties, for the purchase or sale of specified stocks, a specified commission is charged by the party who does not hold the right or the option of sale or purchase.
- An option means that the party has the right and the ligation to buy or sell the stock. In short, the option holder is not under any obligation, however if the option is not exercised, the commission is lost.
- The rise and fall of market prices of stocks is the chief area where investors focus. The price of stock in a stock option is predetermined. In future (that is within the time span of the option), if the prices of that very stock rises above this value, then the option of purchase is exercised, and the stock purchased at a lower price through the option right. It is sold in the stock market at quite a higher price.
Stock options are usually utilized by investors as a tool of arbitrage, that is it helps them to buy at quite a lower price and at the same time, it helps them to sell almost simultaneously at a much higher price. The predetermined price and the right without any obligation, is the key to the success of this security.
Common Types of Stock Options
The following are the three common types of stock options.The first two are the functional classifications.
1. 'Call' Stock Option
As mentioned above, the stock option is a right to purchase or sell. A call option is a right to purchase from the current owner of the share. One common strategy is to purchase the option when price of the stock in the market rises above the predetermined agreed price. This option is held by the buyer.
2. 'Put' Stock Option
The 'put' option is the option or the right but not the obligation to sell. This option is usually resorted to when the market price of the stock falls below the predetermined price. This option is held by the current owner of the stock.
3. Employee Stock Options
In an effort to build and enhance proper and better employer-employee relationship, several companies issue options to their employees. As per these options, the employees can purchase stock at a lowered rate within a specified time or on a specified date. In some cases, such an option is a part of the company's sweat equity.
Stock option is a very useful instrument for institutional as well as non institutional investors. The loss of commission if the option's right is not exercised is a prominent drawback of such an option. However, if handled cleverly, these options are excellent instruments to profit.