UK Accounting Glossary
A stock option is the right, but not the obligation, to buy or sell a stock at a specific price for a specific period. The trader holding the stock option (i.e. the buyer) pays the trader issuing the stock option (i.e. the writer) a premium for that right. The price at which the stock option can be bought or sold is called the strike or exercise price. When a stock option represents the right to buy, it is referred to as a call option; when a stock option represent the right to sell, it is referred to as a put option.
For example, assume a buyer places a call on stock XYZ at a strike price of $50 with the stock trading at $45 and a stock option premium of $5 per share. If the stock price were to climb to $55 before the expiration date, the stock option buyer could purchase stock XYZ from the writer at $50 and immediately sell it on the open market for $55 to break even ($55 – $50 + $5=$0). If the stock price were to climb higher than $55, the stock option buyer would profit. On the other hand, assume a stock option buyer places a put on stock XYZ at a strike price of $40 trading at $45 with a stock option premium of $5 per share. If the stock price falls to $35 before the expiration, the stock option buyer can purchase stock XYZ for $35 on the open market and sell it to the writer for $40. Again the stock option buyer breaks even ($40 – $35 + $5=$0). If the stock price drops below $35, the buyer profits. The above examples do not take into account the commissions required to execute the stock option and applies to American-style stock options. A European-style stock option works in the same way except that it can only be exercised upon expiration. A capped-style stock option can also only be exercised upon expiration unless the stock price reaches a specified limit (i.e. cap) at which point the stock option is automatically exercised. Aside from these three commonly traded styles, there are also a wide array of privately traded exotic stock options featuring complex variations on puts, calls, strike prices, and exercise methods.
Employee stock options, issued by companies to foster a vested employee interest in company success are only issued as call options. In most cases, an employee stock option can only be exercised after an employee has been with a company for a minimum period of time.
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This glossary post was last updated: 5th February 2020.