A stock option is a contract to buy (known as
contract) or sell (known as a "put"
contract) securities, often shares
of stock, at a predetermined or calculable (from a formula in
the contract) price.
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, as 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. The problem of calculating exactly
the how much that option is worth has been the subject of much academic
and practical interest for the last 40 years. The most popular method
used in the financial
markets is to use the Black-Scholes
formula, but this depends on the option
Options themselves are traded as securities on stock exchanges.
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.
Because stock prices are related to corporate earning, the granting
of stock options gives an employee an incentive to increase earnings,
either in reality or possibly by the use of creative
accounting. It is estimated that over-reporting of income by
an average of 25% by American corporations was one cause of the
Market Downturn of 2002.